If bond yields are significantly below the level of expected nominal GDP growth then investors are either not getting rewarded for the inflation component or would be better off in a higher real return asset such as equities where corporate earnings are expected to growth in line with the economy.
Too simplistic
The shifts in asset allocation would push bond yields higher. If yields were significantly higher than nominal GDP growth, investors would be attracted into bonds and this would push yields back down.
This simple way of looking at bond yields seems unrealistic in today’s world. However, historically, for the key developed bond markets, long-term government bond yields have tracked nominal GDP growth relatively closely. The idea that bond yields should be related to long-term nominal GDP growth provides support for those investors that see government bonds being very expensive today as current yields are well below nominal growth, even if nominal growth expectations are lower than in the past (2.5% real growth and 2.0%-2.5% inflation in most developed economies).
Expectations of a rise in bond yields back to some kind of long-term equilibrium value are based on the notion of monetary policy normalisation (higher interest rates) and/or some increase in the inflation risk premium embedded in the nominal yield curve as a result of the extraordinary monetary policies in place since the financial crisis. The problem is, an investment strategy based on this view has not delivered the performance expected by bond market bears.
We need to go back to the original formula for assessing long-term bond yields and put much more emphasis on the risk premium. The sovereign debt crisis is about the divergence in risk premiums between sovereign issuers. We can divide up the world now into those sovereigns where current yields are well above the level of long term nominal GDP growth (there is a positive sovereign credit risk premium) and those where the level of yields is below the long-run nominal growth rate (a negative risk premium).
Austerity needs
Of course, it becomes somewhat self-fulfilling. Where there is a positive risk premium and yields are above long-run nominal growth, debt dynamics will worsen as the sovereign’s funding cost is above the economy’s ability to generate enough tax revenue to service the debt. As such, the credit metrics worsen, forcing governments to undertake austerity policies in order to try to arrest the deterioration in the fiscal outlook.
For some, it may have already gone too far – Greece, Ireland and Portugal have had to seek external financial assistance to cope with their debt dynamics and we have already moved into the realm of debt restructuring for one of those.
Gilts have outperformed Treasuries (as have Bunds) last week. The US and UK ten-year benchmarks are now trading on the same yield for the first time since 2006. Indeed, one really needs to go back to 1999-2000 to find a period where US yields were higher than gilt yields for a prolonged period of time.
Good for UK
The UK’s AAA rating is no longer under threat and, although there is some disappointment with the speed of fiscal adjustment, the outlook for the deficit and the debt level is more favourable for the UK than for the US. So gilts may deserve a lower risk premium than US government bonds and the outperformance of the UK market is likely to continue in the short term, or until the US sorts out its political mess.
The UK as a safe-haven – who’d have thought? Where else? Swedish, Canadian and Australian bonds look relatively attractive in this environment of sovereign credit deterioration while the Swiss franc has continued to motor on as the world’s strongest currency. The problem is, you don’t earn much yield in any of these bond markets and fixed income investors who need income have to look at corporate credit and high yield. I believe a diversified exposure to a large number of companies remains a better bet than concentrated exposure to sovereigns with a questionable ability to reduce their leverage over the long term, especially where current yields are lower than their long-term equilibrium.
