Why Bond Markets are the Key to Everything

With the budget due tonight, expect wall-to-wall coverage over the next few days. I’m not going to add anything to that wall today or for the next couple of days. I’ll wait for the dust to settle before throwing in my two cents.

I just lament the fact that this will be a vote winning budget…pandering to special interest groups rather than doing what’s best for Australia’s long term interests.

Ah well, what did I expect?

Let’s move onto more important topics, like global bond markets. It sounds boring I know. But an understanding of what’s going on here could give you a big advantage in managing your portfolio over the next few years. It does get a bit technical, but the discussion is necessary to explain how government bonds determine the price of most other financial assets.

So what’s going on?

Global bonds were back in focus overnight. The ever-present concerns over a Greek default or exit from the Eurozone sent bond yields in Europe higher. German 10-year yields increased six basis points to 0.61% while the Spanish 10 year yield rose eight basis points to 1.75%.

When bond yields rise, it means their capital value falls. So if you’re invested in a bond fund, falling yields are not good for your account balance.

The problem is, government bond yields have been falling (and prices rising) for so many years, they can’t go much higher. In recent months, some government bond yields in Europe offered a negative annual rate of return!

So you shouldn’t be too surprised to see yields start to move the other way. The important question, though, is why are they starting to move? Is it simply because global growth prospects are looking brighter?

Generally, long term bond yields should approximate an economy’s nominal growth rate. That is, real growth, plus inflation. Because traditional measures of inflation are so low around the world right now, the ‘inflation premium’ has been virtually non-existent in bond yields.

If global growth is starting to pick up, inflationary pressures are probably raising their head too. If that is the case, then bond yields are simply readjusting to this pick-up in inflation. As long as the inflation is mild, then it’s no big deal.

But what if there is something more sinister behind the moves? What if it’s a general change in perception about the riskiness of government bonds? In that case, it has huge implications for investors.

You could make an argument that European bond yields are on the rise due to increasing concerns over a Greek default. I discussed this on Friday. In short, a Greek default would simply shift the debt burden from Greece to elsewhere in the Eurozone. As a result, bond yields should rise ‘elsewhere’ to reflect this increased burden.

But what about in the US? The US bond market is the largest and most important in the world. Since bottoming in February at a yield of just under 1.7%, the 10-year treasury bond now yields 2.28%. That’s quite a rise in a short space of time.

But if you look at the chart below, which shows the last five years of US 10-year yield movements, you can see that the recent move is not out of the ordinary. That is, bond yields are volatile.

US treasury yield

Source: StockCharts.com

Click to enlarge

The important thing to work out is whether the long term trend has changed. You could make an argument that the bond bull market (which started in 1981 when yields were around 15%) finally peaked in July 2012 when yields hit a low of nearly 1.4%. (Remember, falling yields mean rising prices, hence the bull market in bonds).

Yields then rose sharply in 2013, peaking around 3%. The market moved too far, too fast though. During 2014 bond yields fell again, this time bottoming around 1.7% in early 2015.

This was a ‘higher low’ on the chart, and could be a warning sign that the long term bottom for US government bonds yields was indeed in July 2012. If that is the case, then the long term bull market in bonds is over…and you should expect high yields and lower prices in the years to come.

It doesn’t really matter what causes this to happen…less confidence in government, higher inflation…unsustainable debt growth. What matters is that when a trend changes it tends to continue for years.

In the case of US bonds, the demand and supply dynamics are much different now than they were a few years ago. For years, the US could always rely on emerging market central banks to absorb the flow of treasuries.

But now, emerging markets have other worries on their plate. Economic growth is slowing and they’re trying to contain inflation and support their own currencies. They have far less need for US bonds now.

News from Bloomberg supports this dynamic:

The Treasury Department is finding that demand for U.S. government debt is no longer insatiable.

Demand for the U.S. government securities sold at auction has declined in each of the past three months, after also slumping in the August-through-October 2014 period, data compiled by Bloomberg show. That’s a far cry from the surging investor interest that pushed demand to a record in 2012.

That’s what happens when a central bank bid exits the market. That the US Federal Reserve no longer buys up billions worth of treasuries per month means that yields must rise to entice buyers.

And that’s exactly what you’re seeing now.

What’s the big deal though? Why is the bond market so important?

According to standard finance theory, government bond yields represent a ‘risk-free’ market rate of interest, and the market prices all other assets using this risk-free rate as the benchmark.

Let me put it in terms of how you might think about stocks. Back at the start of the bond bull market, treasuries had a juicy yield of 15%. Let’s call it an ‘earnings yield’ of 15%.

An earnings yield of 15% is equivalent to a price-to-earnings (PE) ratio of 6.66 times (1/15). Back in the early 1980s, the stock market traded on a PE multiple of around 5-6 times. It was so ‘cheap’ because the bond risk-free rate was so high.

Over the next few decades the risk free rate slowly but surely fell, which ensured the market’s average PE ratio increased. Think of it like a see-saw…bond yields down, market PE up….and vice versa.

Now, with a risk-free rate of around 2.3% on US treasuries, it’s the equivalent of saying bonds trade on a PE of around 43 times. That’s massively expensive and makes the stock market look cheap.

In absolute terms I wouldn’t say the stock market is cheap at all…but relative to the bond market it’s not half bad.

But comparing bonds with equities is not an apples for apples comparison. You have to account for the increased risk that investing in equities brings. To do so, finance theory says you add on an ‘equity risk-premium’ when considering equity investments.

Adding a risk premium of around 300 basis points to the risk-free rate gives us 5.3%. That converts to a market PE ratio of around 19 times. Based on current S&P500 earnings of $102.88, that’s pretty much where the market sits right now.

The upshot of all this is that if the long term trend in bond rates HAS changed, then bonds AND equities are at risk right now. There just isn’t much room for error.

So keep your eye on bond markets. They hold the key to everything in the markets.


Greg Canavan+,
For Markets and Money, Australia

PS: If you’re looking for a decent income stream in the market, it’s more important than ever to make sure you do so with your eyes wide open. Our new Total Income advisory is all about getting access to ‘safe’ income streams. Click here to find out more.

Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing. He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’. Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors. And, through the process of confirmation bias, you tend to sift the information that you agree with. As a result, you reinforce your biases. This gives you the impression that you know what is going on. But really, you don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. He sees opportunities in crises. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines charting analysis with more conventional valuation analysis. Charting is important because it contains no opinions or emotions. Combine that with traditional stock analysis, and you have a robust stock selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the same mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Markets & Money here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:

Leave a Reply

Your email address will not be published. Required fields are marked *

Markets & Money