Virtually every forecaster got bonds wrong this year.
Large yield falls reflect an interaction of three drivers. A rapidly escalating global trade conflict pushed central banks into major easing moves and fed strong demand for safety and duration.
Yield drops, mostly ‘real’ rather than ‘inflation’ – led, are large enough this year to imply a global recession call. Until it arrives, however, a mild rebound in yield falls looks possible.
Longer-term yield drivers remain bond-friendly.
Read the article below for more information about global bond yields.
Just about every forecaster got bonds wrong this year
Last November, when the US ten-year benchmark treasury yield reached, what from today’s vantage point seems like the lofty height of 3.2%, the mean consensus forecast(1) 12 months ahead, i.e. November 2018, was for yields to climb further, to 3.5%. More telling was that only one forecast saw falling yields in 2019 (well done CitiGroup), though only by 0.3%. Even by January 2019, by which time the US Federal Reserve had done its (in)famous pivot of a sudden rhetorical switch from tightening to easing, pulling ten-year bond yields 50bps lower to 2.7%, a similar result held. Only one forecast (HSBC this tme) saw yields lower for 2019 (though only by 20bps). The mean forecast was for yields to climb 50bps thought 2019 to reach 3.2%.
This is a good illustration of how just about every forecaster has got bonds wrong so far this year, including us. It is ‘just about everybody’ because there will always be some forecaster somewhere, who did get it right. Our one year ahead projection for fifteen-year duration US treasury yields at the start of 2019 had been for a 20bp move higher, slightly ahead of the bond market’s implied view derived from the yield curve. Our implied ten-year bond yield forecast would have been for yields to have been broadly unchanged from start of year levels of 2.7%. Less wrong than consensus yes, but very far from what now looks likely, given current ten-year yields are now at only 1.7%.
(1) Consensus Economics – a wide compilation of forecasters’ expectations from sell, buy and independent research for major developed and emerging markets.
This powerful bond rally in 2019 is entirely global. The US, furthest away from zero (or negative) policy interest rates has had eye-catching yield falls, but even those starting with yields close to the zero mark have not been holding back (see chart above). Germany and Switzerland are now deeply negative- yielding, now joined by France, the Netherlands and more. Only Japan has bucked the trend with far smaller yield falls, but this is a heavily managed bond market. It is revealing that Italy, with an unsustainable burden of government debt, shows the heftiest yield fall of all, such has been the power of the global bond rally.
More of the fall in yields come from the ‘real’ yield component rather than the ‘inflation’ one. Taking the US ‘long bond’ 30-year maturity, approximately ¾ (60bp of the 80bp fall in yields in the year to date) of the change is from falling real yields.
Three big bond-friendly surprises
Cynics will say that this is not the first time a large majority of forecasters have had bonds wrong. For many years, forecasts have generally erred in underestimating the duration of the longterm trend of lower yields. Even so, such an overwhelming forecast bias for higher yields seen this year is unusual.
What seems to have happened is that the world has looked very different in recent months to what was anticipated only recently. There have been three big surprises which shed some light on the ‘why did so many get it so wrong?’ question. A quick read will show that the three have worked off each other.
1. 2019 escalation in trade conflict
The escalation in trade conflict is large and so is the slowdown in the global economy. Though many, like us, expected trade conflict to be ongoing, most did not expect the degree of escalation seen this year. Until a few months ago, talk was of a trade agreement or at least a truce to prevent escalation. Instead, new tariffs are coming in. By September, US tariff hikes on Chinese goods will cover 97% of US imports from China and the average tariff on these will have risen from 3% to well over 25% in just two years. There is a growing view that trade conflict with Europe will build soon. This escalation has fed fears of a
deeper global economic slowdown, if not a recession. As we pointed out recently, global trade could be on the verge of shrinking outright. The US being a more closed economy than most suffers less, but even here trade is now a clear drag. Trade conflict has been the best friend of the bond market this year.
2. Central bank easing trend has been sudden and large
The US interest rate pivot at the start of 2019 was spectacular. Last November, largely taking its cue from the Federal Reserve, interest rate markets anticipated a move from the then 2.25% Federal Funds rate to 3.25% by the end of 2019. A month later, the Fed changed its tune radically, implying rate cuts instead. Just a few months later, that same expectation had fallen to a lowly 1.75% This is some shift! The US is the biggest, but far from the only surprise. The European Central Bank has shown no hesitation from talking rate cuts even with existing zero or negative policy rates. China has accelerated its monetary easing to cushion the trade impact. Australia, New Zealand, Brazil, Chile, South Korea and Thailand are among a long list of central banks that have been cutting rates after the recent US rate cut.
Why the concerted trend towards easing? Partly because growth has weakened in many economies in 2019, more so than earlier expected. But there is another important reason which explains the Federal Reserve’s urgency at a time when the US economy still appears to be holding up well. When policy room is small, the policy logic is that there is a need to be proactive and cut rates earlier to maximise bang for buck and to ensure that policy room is not exhausted later. The US has less than half the policy room to cut rates than in previous post-war rate cutting phases (2.5% instead of over 5%). Whatever the driver, the swiftness and the scale of global monetary easing has clearly been a big driver of lower bond yields this year.
3. The duration ‘premium’ goes even more negative
It was bad enough that the term or duration premium – the additional reward that investors taking inflation or interest rate risk in holding longer duration bonds - had been negative for some years. This was rationalised, by the Federal Reserve itself, to be a direct result of its quantitative easing policies, which brought a big price-insensitive buyer of duration not seen before (see chart). While the occasional rush to safety has produced near negative term premiums in the past, as seen during the last financial crisis, the large move into more negative territory recently has been one of those surprises jolting bonds. This is a key reason for the well flagged move to yield curve inversion (long duration yields below short duration yields or policy rates).
The US bond term premium has become ever more negative
Source: New York Federal Reserve, Bloomberg
The market might reasonably have expected that once the Federal Reserve had stopped buying bonds and began running its holdings of US bonds down (2017), the downward drive in the term premium would halt, or even reverse. There has also been very large US treasury issuance to finance the large budget deficit which should also have countered falling term premiums. Neither worked this way. The only explanation that works in explaining the contrary trend of the term premium going more deeply negative is that the bond market is, in fact, assigning a strong likelihood towards zero interest rates arriving in the US. If the Federal Reserve eventually lowers rates to zero (or near it), the term premium is then not as negative as it looks. It is also quite plausible that the bond market expects a restart of quantitative easing in and beyond the next recession.
Longer-term drivers pull yields lower too
We should note here that what we have just discussed are medium-term factors that are influencing the direction of yields and the slope of the yield curve. The structural factors that have driven bond yields lower over for the longer-term have a different flavour. Those factors, which we have discussed in other notes, include population ageing, the continued excess of global savings over investment and increased banking and broader financial regulation which has driven up the demand for safe assets. It has been our view for some time that none of these factors are signalling a change of direction. By and large, these factors continue to pull yields lower, even when medium-term factors are pulling them higher. This was seen during 2018 when yields rose steadily, only to reverse in 2019, when these shorterterm yield drivers discussed above were on the same side as the longer-term factors, reinforcing the downtrend in yields.
So, what now?
The relevance of looking back at 2019 should now be apparent. What happens to bond yields as we look ahead to the next year or two will depend on whether the three surprise factors which have driven yields decisively lower this year will continue to strengthen or weaken as we look ahead.
Will trade conflict effects worsen? We have until recently regarded trade conflict as an ongoing set of serial shocks to markets rather than necessarily bringing much worse. Now, after the latest tariff announcements, we are closer to the tipping point at which bigger dangers loom. Assuming the latest planned tariffs vs China come in and the conflict is widened to Europe, the global economy faces higher recession risks arriving sometime over the next 12-18 months. It is true that the US Presidential election in 2020 is one reason to think that escalation may be avoided from here as dangers to the incumbent from conflict escalation may become too high. However, the damage already done cannot be easily undone. Much like the bond market-derived recession probability, currently at a high 1 in 3 over the next 12 months, we see raised risks that much poorer economic conditions arrive.
Bottom Line: This keeps market conditions bond-friendly.
Will central bank easing moves pull yields lower still? We struggle to see how this could continue to be a yield-reducing driver. Bond markets have been aggressive in lowering interest rate expectations. Rate expectations are scouring the floor already. The bond market expects the Federal Reserve to cut rates a further 0.5-0.75% in the next six months, and quite aggressive easing moves are already priced into many curves today such as a move towards zero interest rates in the UK even with inflation remaining above target. These interest rate expectations may indeed be met, but unless rate cut expectations deepen, this should not be pulling yields still lower. In effect, the bond market is already pricing in recession or nearrecession conditions. We see this as already gloomy enough to allow for the darker economic outlook.
Bottom Line: If economic fears abate even a little, some reversal in yields looks possible though we do not think any rebound in yields is likely to be particularly large – of the 20-30bps type.
Will the duration premium move still lower? It is difficult to have much conviction on a view here given that the trend has been in the opposite direction to what has been generally expected in the recent past. A negative duration premium is really a duration penalty. Investors have not been deterred by it to date, so why should they now? Partly because there is some risk to taking duration at this time. It is now looking much more likely that the policy response to any recession will involve more government spending, possibly financed directly by QE. This should at some stage bring some notion of risk back into pricing at the longer duration end of bond markets, less a risk of default but more on inflation or faster than expected rises in policy rates. Against this, it is possible that this policy response fails, and the US and other global economies repeat the Japan experience since the 1990s when stepped up government spending and QE failed to stem prolonged growth weakness amidst deflation. If Japan is the destination, no risk element will enter the bond market. To argue that term premiums will move still more negative now can only be warranted by the Japan example.
For those less gloomy, there will probably appear a limit somewhere to how low relative to the profile of expected policy interest rates long duration yields can go. Of course, if a recession arrives this could arguably take term premiums lower still for a time even though, much like interest rate expectations, very negative expectations are already in bond prices.
Bottom line: We regard the term premium driver of yields to be neutral for the next year or two, regarding the steep move into a deep negative level to have priced in recession risks.
Bringing it together
2019’s yield collapse was very difficult to anticipate as market conditions tilted drastically towards favouring bonds. A worsening trade conflict risks provided the backdrop; a large US interest rate pivot was instrumental in setting up the trend; finally, the bid for safety and duration moved to extreme levels.
However, further large drops in yields will probably now only be seen at the onset of a global recession. Trade conflict escalation of the type recently seen could bring this spectre closer, but until we see a recession arrive, there is a chance of a reprieve with a mild rebound after the large yield falls that have been seen. This could come from a temporary easing of trade conflicts and/or a more gradual pace of Federal Reserve (or other central bank) easing than currently assumed.
This view of a pause or mild reversal in the global bond market rally recently seen does not imply that the long-term trend towards lower yields is reversing. We noted that structural bond yield drivers remain bond-friendly. Hedging positions for interest rate risk in liability management should continue allowing for the prospect of yields going still lower, everywhere.
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