The Yield Curve Conundrum “Bond Yields” a shrinking source of income
“Bond Yields” a shrinking source of income Mark Kiely Antares Fixed Income Portfolio Manager
Executive Summary The disinflationary trend of the past 12 months has seen global bond yields fall dramatically to multi decade lows. Japan and the EMU have implemented aggressive quantitative easing programs in response to their stalling economies being faced with disinflation or deflation. The risks in bond markets may still be symmetrical. If the current market pricing of bonds proves correct, and inflation falls for an extended period, yields may still fall a long way. If the current market pricing of bonds proves incorrect, and inflation rises, the ensuing bond bear market would prove most painful for investors.
Recent Themes 2013 / 2014 Key Themes • US rate rises anticipated – risk of rising rate structures – QE tapering • Credit cycle mature – risk of an end to the crowded carry trade What happened • Rates went lower, Japan/EMU QE replaced US QE • Credit assets continued to perform
2015 Key Themes • Deflation – driving yield structures lower and flatter • Lower terminal cash rates – rates lower for longer • EU geopolitics (Russia, Greece potentially exiting EMU, Europe and Militant Islam, rise of populist parties) What will happen next?
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Global Rate Structures – where are we now? Global rate structures are at extremely low levels led by EMU and Japan. Inflation expectations as measured by the market’s pricing of inflation risks have fallen substantially. The chart below shows the recent 5 year range of global sovereign 10 year yields compared to the 5 year average and the current yield. As can be seen the majority of regions have sovereign 10 year yields trading at 5 year lows.
Source: Antares Fixed Income using data from Bloomberg LP
In addition the market is expecting global cash rates to be lower for longer. The chart below shows the recent 5 year range of global sovereign 2 year yields (proxy for rate cycle expectations) compared to the 5 year average and the current yield. As can be seen, the majority of regions have sovereign 2 year yields trading at 5 year lows.
Source: Antares Fixed Income using data from Bloomberg LP
The above scenario stems from a collapse in inflation expectations. The lowering of inflation expectations has resulted in a “lower for longer” view on cash rates that translates to flat yield curves.
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The chart below shows the recent 5 year yield curve range (2-10 year yield spread) compared to the average and the current yield curve spread. As can be seen the majority of regions have their yield curves trading at or close to 5 year lows (i.e. flat yield curves). Italy and Spain are exceptions due to the implied credit risk retained within their sovereign yield curves (albeit substantially less than at the height of the EMU crisis). Switzerland is the other notable exception with its current curve relatively steep due to short bond rates being driven well into the negative yield zone due to the Swiss National Bank recently abandoning their exchange rate ceiling against the Euro.
Source: Antares Fixed Income using data from Bloomberg LP
These developments present challenges to managing a portfolio. As yield curves are very flat and base rates are very low;
The yield enhancement for term extension is unrewarding relative to history.
It’s more difficult to find attractive duration strategies.
Duration would appear riskier now compared to any period in recent years.
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Global Inflation Rates – now and the market’s expectations Disinflation/deflation was a key theme for the second half of 2014 and that theme continues as we move into 2015. Disinflation has been a continuing global trend for many years but gathered market focus and momentum as the price of oil collapsed. Other drivers include excess global capacity, weak consumption cycle, USD strength, falling commodity prices, lacklustre global growth, lack of wage and income growth, plus soft credit creation cycles. Global medium term inflation expectations have fallen substantially. The chart below shows the historical moves in 5 year inflation expectations in the post GFC era (as measured using 5 year inflation zero coupon swap, ZCS rates). Late 2008 saw a globally synchronised collapse in inflation expectations as the financial markets priced in deflation during the depths of the GFC, before recovering in 2009/2010. Since early 2011 Europe, along with Australia has seen a steady trend of falling inflation expectations while the US traded in a 2%- 2.5% range before falling more recently as the price of oil collapsed.
Source: Antares Fixed Income using data from Bloomberg LP
In the second half of 2014 the fall in the price of oil drove US inflation expectations lower. The chart below shows that as oil (blue line, axis LHS) has fallen from in excess of $100/b to $45/b, US 5 year inflation expectations (as measured by the 5 year inflation ZCS (red line, axis RHS)) has fallen from 2.4% to sub 1.5%.
Source: Antares Fixed Income using data from Bloomberg LP
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The market appears to be extrapolating the fall in the current inflation rates many years into the future. The table below compares global current Year on Year (YoY) inflation rates and 5 year expected average inflation rates. These are measured using bond break even rates (BEIs) or inflation zero coupon swap rates (ZCS). As can be seen, although inflation expectations have collapsed, the majority of regions still expect higher average inflation over the next 5 years than the current YoY print, with Japan being the notable exception. The immediate impact of the 50% plunge in oil is lowering headline inflation readings. Should one extrapolate the fall in current headline inflation numbers?
Source: Antares Fixed Income using data from Bloomberg LP
Inflation is low and the market is pricing for low inflation to continue, evident from low and flat bond yields. Is the market correct and are portfolios ready if they are wrong? The fall in the market pricing of inflation expectations has not been matched by the fall in inflation expectations as measured by surveys. As such, it could be argued that the fall in bond yields has also been a function of a reduction in the inflation risk premium required by investors to compensate them for the uncertainty around the future path of inflation.
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Global Interest Rates – historical perspective In the early 1990s Japan’s bubble collapsed, cash rates and bond rates fell and never recovered. Europe currently exhibits many similarities with Japan’s “post bubble collapse” period. Both regions have disinflation/deflation, lack of structural reform and aging demographics. Japan’s interest rates are structurally low and have been since the mid-1990s, might this be the future of Europe? The chart below shows JGB 10 year bond yields since the mid-1980s.
Source: Antares Fixed Income using data from Bloomberg LP
US cash rates and 10 Year bond yields are broadly at the lows of the last half century. Longer term yields can fall lower if deflation takes hold (like in Japan during the mid 1990’s). Alternatively if falling inflation expectations prove incorrect then US rates risk reverting back towards historical norms at some stage.
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The chart below shows US 10 year Treasury yields over the last 50 years.
Source: Antares Fixed Income using data from Bloomberg LP
US 10 Year bond yields are approaching the lows of the post GFC era. This is only justified if deflation risks are real or if there are demand / supply imbalances in the market. The chart below shows US 10 year Treasury yields in the post GFC era.
Source: Antares Fixed Income using data from Bloomberg LP
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Current Yield Curves European yield curve structures have fallen to levels more akin to the Japanese yield curve – note the three lowest sovereign curves in the graph below are for France, Germany and Japan. Italy (the orange line in the chart below) trades higher but that is a reflection of credit risk rather than the risk free rate structure. The US yield structure (along with Canada and Great Britain) trades substantially higher than the European or Japanese equivalent. The Australian yield curve is still a standout. The following regional groupings exhibit different yield curve structures; 1.
Europe and Japan
2.
US, Canada and UK – Dollar block
3.
Australia
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The chart below shows various global yield curves as at 23 January 2015.
Source: Antares Fixed Income using data from Citibank Yieldbook
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Potential Drivers of Future Rate Structures Some potential drivers of steeper curves and higher rate structures include: •
Inflation expectations have been driven too low – inflation surprise risk is thus rising.
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Geopolitical risks – especially EU.
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Re-leveraging – although seemingly unlikely.
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Central bank (CB) reaction times – faced with the dominant deflation risks CBs may be slow to react to signs of rising inflation.
Some potential drivers of flatter curves and lower rate structures include: •
Continued de-leveraging - indebted economies are less able to withstand higher rates/yields. Global deleveraging did not really occur during the GFC / EMU Crisis – merely shifted from the private sector to the government.
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Lack of global economic growth.
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Continued disinflation or outright deflation – past inflation cycles were linked to credit creation but with the deleveraging cycle continuing, inflation is unlikely to re-emerge.
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Demographics – Aging EU demographics – Post Japan’s bust in the early 1990s its aging demographics have hindered the recovery with its population focussed on capital preservation and consequentially, a very conservative investment culture with savings heavily overweight cash and bonds.
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Central Bank intervention / QE - and reaction times.
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Potential Rate Structures under Varying Scenarios The chart below shows the US treasury yield curve as at 23 January 2015 along with some potential future US treasury yield curves under different scenarios. The scenario set provided is for illustrative purposes only - excluding the scenario of a “Japan style” deflation driven collapse in the US rate structure, the risks may no longer be symmetrical?
Source: Antares Fixed Income
The chart below shows the Australian Government yield curve as at 23 January 2015 along with some potential future Australian Government yield curves under different scenarios. The scenario set provided is for illustrative purposes only – the global appetite for Australian bonds has the potential to create high volatility in Australian yields under various inflation and growth outcomes. In adverse scenarios such as a China recession, Australian bonds could be priced as “emerging markets”, as happened in early 90’s and early 2000’s.
Source: Antares Fixed Income
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Current Bond Yields and Breakeven Yield Changes Why bond managers no longer sleep well at night? As rates around the globe have fallen the margins for error have tightened. The “breakeven” rate, or the margin for yields to rise before wiping out the income yield, has more than halved since the GFC. For example; •
At a 4% yield a 10 year bond required rates to sell off by around 0.50% over a year before all income yield would be lost and returns risked being negative.
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At the current US 10 year bond yield of 1.80% (26 Jan 15), rates only need to rise by around 0.20% over the next year to result in negative returns.
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Source: Antares Fixed Income
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The Future for Income Producing Strategies within the Global Debt Markets Where are returns going to come from within the debt asset class, and what are the risks incurred in generating those returns? •
Globally, rate duration would appear to carry higher risk now than in the recent past with base rates low and curves very flat. Term extension provides less yield carry buffer given the flat yield curves.
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With inflation expectations having fallen dramatically in the last few years around the globe the cost of protection (e.g. inflation linked bonds or inflation ZCS) may be arguably cheap in some regions.
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Australia’s rate structure continues to provide a relatively high carry and as such is still attractive on a relative basis to offshore investors, thus supporting the Australian yield curve. However, terms of trade shocks, currency weakness or volatility may increase the risk of this appetite falling away.
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Credit is arguably at the mature stage of the cycle but requires a trigger to sell off – absent such a trigger, acceptable risk adjusted returns are still available in some areas, such as good quality investment grade. The Emerging market and High Yield segments are much more exposed to a reversionary trigger event or withdrawal of risk appetite given the crowded carry trade being pursued by relatively hot money players.
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As a result of new regulatory requirements, banks globally are de-risking balance sheets, increasing their capital base, closing proprietary trading desk operations – all of which is leading to lower liquidity in traded assets. The lower liquidity in traded credit instruments will increase future credit volatility, providing opportunities for the nimble and focussed fixed income investor.
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