US government bond yields are reaching new recent lows while economic data, at least in the US, is surprising to the upside. It’s not meant to be that way but it is. This week, we will put some context on what appear to be some conflicting market moves and offer a range of possible explanations.
Bond yields offer an indicator of the market’s collective view of future interest rates, at least in theory. It follows that they offer an insight into the market’s view of future inflation and economic growth prospects. Given that these have been falling, quite rapidly of late, then the market must be expecting a slow down in growth or inflation or both. However, simultaneously, economic data and leading indicators have been improving following last years’ declines, which is inconsistent.
One possible explanation is that the old theory is wrong. In the past, longer term bond yields were seen as a proxy for expected long-term nominal economic growth, and therefore rises and falls were expected to coincide with rises and falls in either growth or inflation expectations. However, if this ever worked, it was in an environment where bond markets were free of institutional interference. Nowadays, the government market participants are rarely making buying and selling decisions based on economic growth expectations, and if so, only at the margins. Most of the big actors are central banks, commercial banks, and pension funds, all of whom are buying for quite different reasons. In the vast majority of cases, the big buyers of government bonds have a huge impact in driving yields lower. Central banks want to create an accommodative monetary environment and certainly want to avoid a future second Global Financial Crisis (GFC). Commercial banks have been given a huge incentive, through regulatory capital rules and access to cheap central bank funding, to hold government bonds so long as there is at least some yield pick up over their cost of funds. Pension fund regulation has created a huge demand for low risk, long duration assets with income and hence drives yields lower again. None of these players are the least bit concerned by the theories contained in market or economic text books, they are simply executing a strategy that makes sense given the real world as they see it.
Looking at markets this way it could be seen as entirely plausible, in the new post GFC regime, that bond yields could remain extremely low and even fall while economic prospects are improving. Essentially, in the post GFC new monetary regime, both short and long-term interest rates are structurally lower reflecting excess demand for low risk assets and the high levels of outstanding debt in the system. In short, central bankers are most concerned about another GFC, and interest rates not being allowed to rise to levels which causes financial distress.
The assumption in the old world would have been that such a policy would have inevitably led to inflation, but many years have now passed and there is still no sign of rises in inflation in the major economies. As we get ever closer to full employment in the US, we might test this, but again it is looking ever clearer that the old economic models are failing. There is perhaps a couple of ready explanations for this and maybe they interlink. One is that inflation in this system shows itself in asset price bubbles, think housing bubbles, excessive venture capital valuations etc., rather than the traditional goods and wage inflation of the past.
A related explanation is that the old models worked very well in a capital intensive industrial economy but the modern economy requires much less capital for investment. Business investment these days often takes the form of software and services which are labour, not capital intensive and often leads to goods price deflation. Full capacity is not a concept that works so well in a modern IT driven and services led economy.
Our conclusion is we are in lower for longer again and will remain so for an extended period, while further refinement of the new monetary regime continues, extending into modern monetary theory and beyond. This implies that bond yields are likely to be capped to the upside and that the valuations of quality growth stocks can at least persist if not extend further, while economic cycles remain subdued for the foreseeable future.
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