Hear ye, hear ye—a momentous event occurred Wednesday: Germany’s 10-year bond yield turned positive! Just barely, and not for long—it ticked back down to -0.013% a short while later.[i] But the brief blip above zero was enough to spur warnings from several financial commentators we follow that rising German yields would suck money out of US Treasurys, sending American long-term interest rates higher—and hurting stocks globally in the process. However logical that chain of events might seem, we think it has little grounding in reality.
For one, we think arguing a German bond (known in Germany as a bund) yielding a whisker more than nothing will pull capital away from a US Treasury note paying 1.83% focuses too much on yields’ direction.[ii] All else equal, our research shows money flows toward higher-yielding assets, which amongst the largest and most creditworthy nations, remains US Treasurys. The gap is wide enough that even if bund yields are positive, European investors can likely still buy US Treasurys, hedge for currency risk and come out ahead. If you were managing a European pension fund and trying to balance long- and short-term obligations, which would you choose? We suspect many, if not most, would likely pick the higher-paying option.
Then again, yields aren’t static. Suppose Germany’s barely positive yield did attract a flood of buyers, who sold their US Treasury bonds. If markets are at all efficient—which we think they are—it stands to reason that German yields would swiftly fall back below zero as buyers bid prices higher (bond yields and prices move in opposite directions). Our research shows bonds move on supply and demand, after all, and German bond supply is extremely tight, so we think it wouldn’t take much of a demand increase to tug yields lower. Meanwhile, we think the world would likely see a chance to buy Treasurys on the cheap, quickly bidding prices up and yields down and leaving everyone wondering what all the fuss was about.
Rather than focus on German and US rates in a vacuum, we suggest considering that bond yields across the developed world tend to be highly correlated, meaning they move together much more often than not.[iii] We have also found that long-term interest rate movements are usually global.[iv] So in our view, the more relevant question isn’t whether incrementally higher German yields destroy US Treasury demand, but whether yields globally are likely to mount a sustained climb. We have our doubts. We think bond markets are forward-looking, and they therefore probably already reflect the upcoming end of quantitative easing (QE) in the US and the reduction of the ECB’s QE—both slated to happen in March, barring a policy shift. This is relevant, in our view, because QE involves monetary policy institutions purchasing long-term bonds from banks, which theoretically puts downward pressure on yields. So, most commentators we follow argue QE’s end should push yields higher. Yet according to our research, QE’s relationship with yields has long appeared to be what many in our industry refer to as the buy the rumour, sell the news variety, with yields moving ahead of expected actions.[v] Ditto for investors’ expectations for the Federal Reserve to raise its benchmark short-term interest rate, which we think is likely a big reason why since 1933, the median 10-year US Treasury yield increase after the first rate hike in a tightening cycle was less than a quarter of a percentage point after 6, 12 and 18 months.[vi]
As for what we think are genuine forward-looking factors, our research shows the biggest influence on bond prices tends to be expected inflation. Not today’s inflation, which is hitting generational highs across the developed world—this isn’t a political statement, but based on how markets work, we think it is quite fair to say bonds already reflect the inflation we are living with today.[vii] We think bonds, like stocks, reflect all widely known information. So the question is not what inflation did already, but how it is likely to evolve over the next 3 – 30 months. Within this window, we think supply chain kinks will likely even out, companies’ investments in productive capacity will probably start bearing fruit, and society will likely get increasingly adept at living with COVID without letting it stop general economic life. In our view, all point to prices rising much more slowly, albeit off a higher base, over the next couple of years—which, in turn, points to bond yields not moving much over a meaningful length of time. That doesn’t preclude short term moves, as bonds are volatile, but we think it is vital that investors not extrapolate the recent past across the future, as past performance just doesn’t predict.
Even if we are wrong and rates rise, that doesn’t mean much for stocks, in our view. Contrary to what several commentators we follow argue, we just don’t see much to suggest that stocks are propped up by ultra-low bond yields. If they were, we think you would actually see a strong negative correlation between US stocks and Treasury yields. Yet the weekly correlation between S&P 500 moves and changes in 10-year Treasury yields is actually slightly positive over the past 20 years, illustrating they move in the same direction a bit more often than not.[viii] If yields and stocks rise together a decent amount of the time, we think it suggests something other than low yields is attracting investors to stocks. We have a hunch that something is a reasonably high likelihood of continued earnings growth as the world gradually emerges from the pandemic, pre-COVID economic trends return and political gridlock generally prevents governments from doing much to mess things up. It may not be a perfect reality, but we don’t think stocks need perfection—just a reality that goes a bit better than investors broadly expect.
[i] Source: FactSet, as of 19/1/2022.
[iii] Ibid. Statement based on 10-year government bond yields in the US, UK, Germany and France, 18/1/2002 – 18/1/2022.
[vi] Source: FactSet and Global Financial Data, Inc., as of 7/1/2022. Median 10-year US Treasury yield change in the 6, 12 and 18 months after initial Fed rate hikes. Deposit rate used pre-1971, fed-funds target thereafter.
[vii] See Note i. Statement based on Consumer Price Index inflation rates in the US, UK, Germany, eurozone and Canada. The Consumer Price Index, or CPI, is a government-produced measure of goods and services prices across the broad economy.
[viii] Source: FactSet, as of 13/1/2022. Correlation between the percentage change of the S&P 500 price index and moves in the 10-year Treasury yield, 12/1/2002 – 12/1/2022. The correlation coefficient is a statistical measurement of the directional relationship between two variables. A correlation of 1.0 implies identical movement, 0.0 implies no relationship, and -1.0 implies they move in opposite directions. Presented in US dollars. Currency fluctuations between the dollar and pound may result in higher or lower investment returns.
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