AGF Investments highlights 'unsustainable' trends and dramatic turn in monetary policy priorities
It may be too early to call an end to the secular bull market in bonds, but investors wary of rising interest rates would do well to keep an eye out.
That’s the word from David Stonehouse, senior vice-president and head of North American and Specialty Investments at AGF Investments.
In a recently published blog post, Stonehouse traced the starting point of history’s best bull bond market back to the early 1980s, when Paul Volcker was at the helm of the U.S. Federal Reserve and Bloomberg data showed short-duration bond yields in the 20% range and long-bond yields around 15%.
“The Volcker Fed drove rates up to break the back of inflation, and while that contributed to the early 1980s recession and a spike in unemployment, the campaign ultimately succeeded,” he said.
In the decades since then, interest rates and bond yields have steadily faltered: as of last year, Stonehouse noted, negative-yielding debt topped US$18 trillion and represented a quarter of all investment-grade debt around the world. Central banks in several jurisdictions including Europe, Japan, and Denmark still have overnight rates set at negative levels.
“We understand that there may be reasons to rationalize sub-zero rates, and that investors can in certain instances still generate returns from them,” Stonehouse said, asserting that negative rates are unsustainable. “Those rationales, however, do not contradict the simple reality that negative rates are antithetical to the way economies should normally work.”
He also highlighted last summer’s policy turn by the Fed under Jerome Powell, which signalled greater tolerance of inflation risk by adopting an average inflation rate targeting regime. While the Volcker-led Fed focused on taming inflation at the expense of economic output and employment, Powell inverted those priorities in the face of more current challenges confronting monetary policy.
“That should have ramifications for the future and, if the Fed succeeds, it could be a major contributing factor to a potential change in trend,” Stonehouse said.
While the shift to higher rates would herald a secular bear market in bonds, nobody should expect it to come anytime soon. Aside from demographic factors and tech-related disinflation keeping a lid on yields, he noted that a fast reset in interest rates would lead to whiplash in the global economy, given the pervasive and astronomical levels of debt across the world.
To comfortably say that the trend has shifted, he said debt levels need to start receding sustainably, which would allow for a secular rise in yields. There would also have to be years of sustained inflation above 2%, as well as a multi-year rounded base pattern in the yield curve, which has historically signalled a secular shift for bond markets.
“Yet despite those caveats, in our view it is prudent to note that the groundwork is gradually being laid for a secular bond bear somewhere down the road,” Stonehouse said.
