Reading the Tea Leaves: Implications of Rising Bond Yields for Asset Portfolios
February 28, 2022
They called it “The Great Moderation”, the period from the mid-1980s until 2007 that saw much of the developed world, including the U.S., successfully keep inflation low and sustain positive economic growth.
In tandem, bonds enjoyed the greatest bull market in their history, with the past four decades witnessing a structurally buoyant environment for fixed-income assets. And this secular bull run went on despite several boom-and-bust economic cycles and consequent disruptions in other asset classes including equities and commodities during that time frame.
Several factors underpinned this bond boom, including a multi-year period of subdued to below-par economic growth post the 2008-09 Global Financial Crisis (GFC), ultra-accommodative monetary policies, and an unprecedented expansion of central banks’ balance sheets via quantitative easing (QE).
Just to put this in context: The Federal Reserve raised its benchmark interest rate, the federal funds rate, to 20%1 in 1980 to kill the raging inflation of the 1970s. And the aftermath of GFC saw the U.S. central bank adopt a “zero-bound” monetary policy for several years, ensuring bond yields currently are hovering at their lowest levels since World War II.
For comparison, 10-year U.S. Treasuries and municipal bonds yielded2 just over 1% and less than 1%, respectively, in the past 10 years, while equities delivered an annualized average return of over 16%.
Fork in the road?
However, is this cycle about to end now? Are we in the early innings of an end to this secular bull run in bonds? Or, is it going to be yet another false dawn for the bond bears, like those who “widow maker trades” involving shorting of Japanese government bonds (JGBs)?
The return of inflation
While various structural attributes, as discussed above, contributed to suppressing – even artificially, many would say – bond yields since GFC, financial repression by central banks during this period failed to stoke inflation. However, the disruption triggered by COVID changed all that, with inflation roaring back in the last 12 months and persisting of late at levels unseen for over a generation.
For instance, the U.S. consumer price index (CPI), the Fed’s principal gauge of inflation, rose at an annualized rate of 7.9%3 in February, its biggest year-on-year leap since 1982, up from the 7.5% increase registered in January. Similar price hikes in core inflation barometers have been recorded in the U.K. and many parts of Europe in recent months.
The bond market has started taking its cues: the Vanguard Total Bond Market ETF (BND), a key benchmark for many investors, lost4 nearly 2% in 2021 on a nominal basis, and almost 7% on a real, inflation-adjusted basis.
The first quarter of 2022 signals the same trend, in terms of investors’ thinking. The yield on the benchmark 10-year U.S. Treasury note hit its highest levels since June 2019, at 2.139%5, on March 14, underlining growing concerns that rates could well be on a structurally upward trajectory now – notwithstanding mounting geopolitical tensions. Even yields on Treasury inflation-protected securities (TIPS), widely considered as a gauge for real bond yields and hence, benchmark borrowing costs, have started climbing up.
Add to the inflation spectre the emerging spike in inflation expectations6, and many asset allocators and portfolio investors have a double whammy to factor in as they think about constructing or rejigging their holdings in this new economic environment.
Impact on equities?
Bond markets historically have anticipated and predicted turns in economic cycles much better than stock markets, with equities investors often picking up “signals” generated in the former to review and calibrate their holdings.
Needless to say, rising bond yields would likely trigger a spike in borrowing costs across the board, thereby impacting economic activity, and fueling volatility in other asset classes including stocks, which ultimately reflect the future earnings potential and cash flows of companies.
Rising inflation and inflation expectations, combined with a steepening bond yield curve, could force the hand of the Fed and its counterparts around the world to finally end their decade-long ultra-easy monetary policies, which have ensured massive levels of liquidity across asset classes.
In conjunction, the planned end of the Fed’s bond-buying program could have its own set of ramifications for bond yields, as a major buyer of U.S. Treasuries steps back, thereby resetting supply-demand dynamics in the world’s most liquid securities market.
Asset allocators and portfolio managers have long embraced bonds when thinking about and deciding on investment avenues, because the asset class historically delivered on its twin promises of ensuring capital preservation and delivering modest returns sans much volatility.
However, the coming 12 to 18 months could well mark a break from this trend, as the equation between bonds, monetary policy and economic outlook looks set for a fundamental realignment.