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Wednesday, July 20, 2016

With a Whimper Instead of a Bang: Is the Great Bond Bull Market Over?

Charles Schwab: With a Whimper Instead of a Bang: Is the Great Bond Bull Market Over?

Key Points

  • Bond yields in major countries have rebounded after plummeting to all-time lows in recent weeks, leading some to conclude that the bond bull market is over.
  • However, the end of the bull market doesn't mean a bear market is starting, as slow global growth, deflationary pressures abroad, a firm dollar and demographic trends are likely to keep yields low.
  • Investors should focus less on short-term changes in the market and more on structuring a fixed income portfolio that can work for them over the long run.
The bull market in U.S. Treasuries looks set to mark its 35th anniversary this fall—assuming it continues. It has been a good run, with investors enjoying attractive returns from their bond portfolios over the years. Ten-year U.S. Treasury yields peaked at 15.84% on September 30, 1981 and fell to a modern-era low of 1.36% on July 8, 2016. (Remember, falling yields reflect rising prices.)

But yields have since bounced back, rising to 1.59% in mid-July. Is this a sign the bull market has run its course? Pundits have repeatedly declared the end of the bond bull market over the years, but, to paraphrase Mark Twain, news of its death has always been premature.

Ten-year Treasury yields, 1970-present

Source: Bloomberg. 10-Year Treasury Constant Maturity Rate (USGG10YR). Data as of 7/15/ 2016. Past performance is no guarantee of future results.
We're not willing to declare the bond bull market over, but we will concede that the recent drop in Treasury yields looked overdone in light of the solid U.S. economic data reported over the past few months. Looking at the U.S. economy in isolation, one would expect investors to be more sanguine. Economic growth is running at a steady 2.0% to 2.5% pace, and inflation is edging higher. Excluding volatile food and energy components, inflation is already above the Federal Reserve's 2% target by some measures. The unemployment rate—at less than 5%—is near where most economists believe the "full 'employment" threshold lies and wages are edging higher for most workers.

Normally, yields fall when the outlook for the economy is uncertain. There is little in the data cited above to support the recent drop.

Moreover, the market probably went too far in reducing expectations for the pace of rate hikes by the Fed. In the immediate aftermath of Britain's vote in June to leave the European Union—better known as the Brexit vote—market expectations for an increase in the federal funds rate this year fell to just 15%. They have since rebounded above a 40% likelihood of a rate hike, which seems more realistic to us.

Implied probability of a Fed rate hike

Source: Bloomberg, World Interest Rate Probability. Data as of 7/15/2016.

Why bond yields will likely stay low

However, bond yields are determined in the global market, and forces outside the U.S. are likely to keep U.S. bond yields low, in our view. The market may have overreacted to the actual Brexit vote, but the specter of rising nationalism and a potential increase in trade barriers suggested by the vote also exacerbated long-standing concerns about global growth. Global trade volumes have fallen to half their long-term historical level in recent years. Since trade is highly correlated with global growth, any indications that the free movement of goods, labor or capital across borders might slow tend to stoke concerns about the global economy.

Gross Domestic Product (GDP) versus Trade Volume – World

Source: International Monetary Fund, World Economic Outlook Database, world gross domestic product and world trade volume of goods and services, annual data as of 12/31/ 2015. Shaded areas indicate recessions.
Consequently, central banks around the globe have been easing monetary policies by pushing short-term interest rates to historically low or even negative levels and expanding bond buying programs. The Bank of England has already indicated it is likely to cut rates in August due to the negative impact that the "Brexit" vote is expected to have on its economy. The European Central Bank has pushed short-term interest rates into negative territory and expanded its bond-buying program to include corporate bonds.

The Bank of Japan is even said to be moving toward dropping "helicopter money" to stimulate its economy. (Helicopter money refers to a concept originating with economist Milton Friedman, whereby the central bank provides money directly to citizens—as if dropping it from a helicopter—in order to increase spending and prevent deflation. In practice it is likely to take the form of the government issuing perpetual debt.) With major central banks already holding large portions of outstanding government bonds on their balance sheets, the potential for higher bond yields appears limited, in our view.

Central banks' holdings of government bonds as share of outstanding debt

Source: Federal Reserve Board (U.S. Fed), European Central Bank (ECB) and Bank of Japan (BOJ) data as of 3/31/ 2016. *Holdings including government debt of Germany and other eurozone countries as of 3/31/2016.
Meanwhile, demand for yield remains strong, especially in countries with aging populations. Pension funds, insurance companies and retirees are all seeking some sort of positive yield to help generate income. With more than $10 trillion bonds priced with negative yields to maturity, investors have driven up the prices of all types of bonds—even the riskiest, such as high-yield corporate and emerging market bonds. As paltry as they are, U.S. bond yields are significantly higher than yields in most other major countries, leading foreign investors desperate for positive yields to the U.S. bond market.

U.S. yields are by far more attractive than yields in other major countries

Source: Bloomberg. Data as of 7/18/2016.
The inflow of foreign capital into the U.S. has boosted the dollar by more than 3% on a trade-weighted basis since the Brexit vote. The biggest increase has been against the British pound, which fell 11% against the dollar, but the euro is down about 3% and even the Chinese yuan is 2% lower. A strengthening dollar tends to hold down growth by making U.S. exports less competitive and reduces inflation because it causes import prices to fall. The trend in the dollar is a key indicator we watch since it often has the same impact as a Fed rate hike—slowing growth and lowering inflation.

The dollar is trying to do the Fed's job for it

Source: Bloomberg, daily data as of 7/18/2016. The U.S. Dollar Index (USDX) is an index (or measure) of the value of the United States dollar relative to a basket of foreign currencies. Past performance is no guarantee of future results.

What to do now:


We've always believed that the bond bull market would end with a whimper instead of a bang. Yields may have hit generational lows, but it's unlikely they will rise sharply or substantially any time soon. The forces holding yields down—slow growth, deflationary pressure from abroad, a firm dollar and demographic trends—are likely to remain intact for the foreseeable future.

We are concerned that in response to these factors, yield-starved investors are stretching too far into low-quality bonds and/or long maturity bonds without getting compensated for the risks. When evaluating a fixed income portfolio here are a few considerations to take into account and some resources to help:

Start with realistic expectations. We don't expect rates to rise soon, but we also don't expect returns for fixed income investors to be as strong in the next year as they have been in the past year. This article explains why market returns may not be as good in the future.

Match your bond holdings to your investment needs. Treasuries and investment grade bonds tend to add stability to a portfolio, while bonds with more credit risk can add income but carry a higher risk of loss. This article explains how to include an appropriate allocation to each, based on what you want to achieve.

Consider a laddered bond portfolio. Bond ladders—an investment strategy in which you purchase individual bonds with staggered maturities, spreading investments across a particular time horizon—are a way to avoid trying to time interest rate changes. The goal of a ladder is to have bonds maturing at set, but staggered, intervals. Short-term bonds provide stability and create opportunities to reinvest if rates rise, while the longer-term "rungs" of the ladder generate income. This article provides more details on how they work.

See the opportunity. Higher interest rates could spell the end of the bull market, as prices tend to fall when rates rise. But higher interest rates would also be a welcome change for investors seeking income in a low-yield world: Rising interest income would be a boon for investors with a longer time horizon. Consult a Schwab representative to get an evaluation of your current bond holdings and help with constructing a portfolio that meets your needs.

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