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Yield is Destiny; Bonds are Back
By Robert Tipp, CFA, Chief Investment Strategist, Head of Global Bonds
Investing through the arc of the COVID recovery has hardly been a cakewalk, and the event horizon is hardly clearing as 2023 progresses. But as bond investors, we shouldn’t lose sight of the fact that bond yields have experienced a historic increase to what will likely prove to be generational highs. This is the positive side of last year’s market rout: with bonds, yield is more or less destiny. These higher yields should easily push bond returns in the coming decade well above those recorded over past decade (Figure 1).
As a result of the COVID recovery, markets have turned back the clock, pushing yields higher and setting bonds up for solid returns in the years ahead. After a recent rally amidst a series of bank failures, we believe long-term yields could drift slightly higher over the near term. In other words, regardless of the short-term movements, we remain at a strategic buying point for bonds.
Looking back over the decades, we can see that yields have passed through various paradigms, as indicated by the low, moderate, and high periods in Figure 2. Reviewing the factors that drove the transitions between outlier periods may give us some insight into where we are now, how we got here, and where we are headed.
The low yields of the Great Depression continued through the second World War as the Fed capped Treasury yields to facilitate government borrowing (Period II in Figure 2).
Most of the blame for rising rates in the 1970s is cast on the pre-Volcker Fed chiefs allowing inflation to get out of control. The 1980’s high, albeit falling, rates were regarded as the legacy of Fed Chairs Volcker and Greenspan waging and finishing the war on inflation.
Following a wave of fiscal consolidation in the U.S. and Europe, inflation from 2009 through 2020 fell to what central bankers deemed to be concerningly low levels of around 1.5% in the U.S. and 1% in Europe (Figure 4).
As a result of this inflation shortfall, central banks’ administered rates were kept at unusually low levels. In some cases, they were complemented by aggressive quantitative easing and low-rate lending programs, the combination of which drove developed market term structures to unnaturally low levels (Period IV of Figure 2).
The emergence from the COVID crisis provided two reasons for higher rates. The first was the booming growth and inflation. The combination of stimulus and reopening enthusiasm boosted demand, while supply remained muted due to a host of factors, including labor shortages and supply chain interruptions. The second “enabler” of higher rates, if you will, was the repaired damage from the GFC and its sluggish, debt-laden, Reinhart-and-Rogoff conditions.1 Consumer balance sheets and financial institutions’ capital positions were once again strong. That combination has resulted in surprising economic resilience. Hence, we should not be surprised to see the expansion continue despite the shift back to a higher range of interest rates (Period V of Figure 2).
So, where to for rates? Short-term outlook balanced …
The combination of significant hikes to date as well as signs that growth and inflation are beginning to moderate suggest that most of the rate hikes are behind us and that upside risk from current levels is limited. Should growth or inflation decline, however, the potential for a drop in rates would also seem limited given the high starting point for inflation and the low level of unemployment.
Near-term uncertainties notwithstanding, looking a few years into the future, it seems clear that given the demographic and productivity paths of most DM economies, the pace of growth and inflation will be lower.
In summary, the historic increase in long-term rates from the COVID lows to levels not seen for decades will provide a formidable tailwind for fixed income. After all, for bonds, yield is tantamount to destiny, and the recent explosion in yields has turned back the clock two decades, setting bonds up for strong returns in the decade ahead.
This material reflects the views of the authors as of December 20, 2022 and is provided for informational or educational purposes only. Source(s) of data (unless otherwise noted): PGIM Fixed Income.
1 Reinhart, Carmen M. and Rogoff, Kenneth S., “This Time is Different Eight Centuries of Financial Folly,” Princeton university Press, 2009.
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