As low bond yields cast a long shadow over fixed income markets, investors are struggling to balance risk and return.
It is tempting to scour Japan’s experience for clues to the fate of today’s extraordinarily low rate environment – and if Japan’s roadmap is any guide to the future, US, UK and German yields can likely fall even further than they already have.
What does it all mean for global fixed income investors now? As they pick their way through an investment universe bloated by increased debt issuance, the advantages of an actively managed approach have been thrown into stark relief.
Conventional wisdom assumes that what goes down must come up – but will it really?
In the absence of the two “bond investor enemies” (growth and inflation), we expect government bond yields to remain low. In Europe, markets have defied expectations that already extremely low government bond yields could not go lower by breaking through the zero rate barrier. As the ECB’s QE programme buys more debt than countries are issuing, the resulting negative net supply pipeline has led to an environment in which nearly 40% of eurozone government bonds trade with a negative yield.
Given the pervasiveness of negative yielding government bonds in Europe, US Treasuries actually look attractive on a relative basis. That relative attractiveness is likely to keep a cap on US government bonds as high quality fixed income investors search for yield.
Additionally, there is historical evidence that the 10-year Treasury yield will remain anchored based on its relationship with the Fed Funds rate. Typically, when a terminal rate is reached at the end of a Fed tightening cycle, the yield curve is inverted (that is, the 10-year Treasury yield is lower than the base rate). Given the challenges we expect the Fed to have in reaching a terminal rate of 2% in the current tightening cycle, we believe that the 10-year Treasury will not go much higher than its current level.
So, if government bond yields in the US and Europe aren’t going up, can they continue to fall? We can look to Japan for clues.