Most commentators see the current ten-year yields of between 1 and 2% in the US and the core of Europe as unsustainably low and therefore expect 2013 to become a lost year for investors in longer dated government bonds. One has to wonder: Can life ever be that simple?
Let’s face it, it is a mathematical certainty that the long period of wonderful returns on government bond investments has come to an end. Treasury yields would have to fall clearly below 1% in order to squeeze another good year out of this asset class. That is unlikely to happen.
It is therefore no wonder that the appetite for more risky, but higher yielding bonds (issued by emerging markets, the eurozone periphery and corporates) is still high. Having said this, we think that any fears/expectations that core sovereign yields will revert to the “old” 3% to 4% range in the coming years is premature.
Yields are more likely to stay around, or slightly above, the current low levels for an extended period. Why?
Frozen yields
Firstly, we do not agree with the view that bond yields are held “artificially” low by central banks. These banks would only wish that they were able to influence financial markets so easily and to such an extent.
If history has proven one thing, it is that manipulation of either currencies or long dated bondyields over an extended period is virtually impossible, unless substantiated by developments in the underlying economic fundamentals.
Of course central banks have had an impact on markets through the purchase of government bonds in their Quantitative Easing programs. However, only a limited part of the QE effort was focussed on long term bonds and that was only the case in the US and the UK, not in the core eurozone.
Another argument for higher yields is the fear of rising inflation. In this context it is interesting to observe that consensus estimates by economists for inflation are lower for 2013 than for 2012. Expectations are for core inflation in developed economies to fall this year from around 2% to 1.7%.
This makes sense, as core inflation is mainly determined by wage growth. With unemployment still high, and with even a historic discussion opening up on the possibility for wage declines in certain sectors, expectations for core inflation should indeed remain subdued for the foreseeable future.
Higher yields unaffordable
And last but not least, bond yields are likely to stay relatively low for the simple reason that our heavily indebted world is not ready to deal with high yields yet. Many people do not realise that the current amount of total debt (sovereign, corporate, consumer and financial) in the developed world amounts to around 350% of GDP. In the late nineties this was only 250% and in the early eighties, when interest rates exceeded 10%, this was as ‘little’ as 150%.
If bond yields would now rise substantially, the current debt levels would gradually become unaffordable and this rise could therefore prove to be ‘self defeating’ in the end. So, even though we may face clearly higher yields somewhere in the future, it will most likely not be in 2013 or even 2014.
Life is never as simple as it may appear at first sight. Bonds are down, but not out.
