What’s the Bond Market Saying?
Imagine this deal: You give the U.S. Treasury a $1,000 loan repayable in 30 years. And in return, the Treasury guarantees to pay you 10% interest every year.
Yes, 10%.
It’s an offer that probably would lead to riots outside local federal buildings as people rushed to get applications, not trusting something this lucrative to the Internet or regular mail.
Yet just two decades ago the Treasury was quite willing to pay 10% on its 30-year bonds -- only to find that there were few takers. The government had to offer more than 13% by mid-1984 to finally entice buyers.
Those yields are ancient history, except for the lucky few who bought bonds in 1984 and still hold them. But there may be a lesson for investors today in the mind-set of the market 20 years ago.
Back then, many investors were too frightened by the bogeymen of that era -- inflation, soaring federal budget deficits and the sense that America was in a sustained decline -- to take a chance locking in long-term interest rates that now look like a gift from heaven.
In recent months, a different kind of fear seems to have permeated bond markets worldwide: fear that long-term interest rates might only go lower.
Investors have been aggressive buyers of long-term government bonds in the United States, Europe, Japan and elsewhere since June, in turn pushing down the yields in the market place.
The annualized yield on the 10-year U.S. Treasury note fell as low as 3.98% last week, down nearly a full percentage point from mid-June. The German government’s 10-year bond yield fell to 3.45%, apparently the lowest in a generation.
By the end of the week some investors were having second thoughts, and long-term interest rates ticked higher.
But the hunger for bonds has been so strong since mid-year, and particularly in recent weeks, that it has triggered widespread discussion on Wall Street about the message of the market.
Could long-term bond yields be headed so low in the next few years that a 4% return today would appear rich by comparison?
Or are bond buyers today making as big a misjudgment as those who were unwilling to buy in 1984?
There are, of course, many players in financial markets, and their motivations for buying or selling at any given moment can differ substantially.
Many bond market pros have attributed some of the recent buying wave in long-term bonds to short-term speculators, such as hedge funds, that seek to make a living riding market rallies wherever they can find them.
To those investors, there is no point in trying to determine whether a 4% yield is a fair long-term return, because that isn’t the reason they’re buying. As long as bond prices are moving up (that’s what makes yields go down), speculators can hope to sell a bond for more than they paid for it -- perhaps in just a few hours or days.
Asian central banks also have been credited with stoking the bond rally. China, Japan and other nations that enjoy huge trade surpluses with the United States have recycled many of those dollars back to the U.S. by buying Treasury securities. The money has to go somewhere, and the central banks know that by buying dollar-denominated securities they can help support the buck’s value, which also means supporting Americans’ ability to buy foreign-made cars, TVs and other goods.
That would help explain the decline in U.S. bond yields. But why have European bond yields fallen even more dramatically?
Michael Rosen, a principal at Angeles Investment Advisors, a pension consulting firm in Santa Monica, points to rising government pressure in Europe and in the U.S. to force corporate pension plans to plug funding shortfalls in their plans.
Pension regulators want the funds to better match their long-term assets with what they’ll owe beneficiaries over the next few decades, Rosen said. One way to do that is to lock in a return on a 10-, 20- or 30-year government bond, as opposed to taking a chance on uncertain stock market returns.
If this idea catches on, it could mean robust demand for long-term government bonds for years to come -- and continued downward pressure on those yields and others that they affect, such as mortgage rates.
But all of these factors affecting bond yields are ancillary to one other: What is the long-term outlook for inflation?
If you think that inflation worldwide will rise in the next decade, you wouldn’t want to lock in current bond yields. Inflation eats away at fixed returns.
U.S. inflation, by various measures, is in the range of 2% to 3% (at an annual rate). If it were to jump to 4%, suddenly the real, or after-inflation, return on a 10-year Treasury note would be nearly zero. Hardly attractive.
Moreover, higher inflation would require the world’s central banks to raise short-term interest rates.
The Federal Reserve has been lifting its benchmark short-term rate since June, with the stated goal of keeping inflation suppressed by gradually making money less available.
Do falling U.S. long-term bond yields say that investors believe the Fed soon can declare victory and halt its credit-tightening campaign? Maybe.
There also could be a more dire message in the bond market’s trend: Perhaps global economic growth is poised to slow dramatically in the next few years. That could unleash fear of deflation, rather than inflation. In that environment, stock market returns could be abysmal, and someone who locked in a 4% bond yield today might look brilliant if interest rates in general were sharply lower.
But some bond market veterans say it’s an exercise in wishful thinking to imagine a steep further drop in bond yields.
In the early ‘80s, investors were afraid to lock in double-digit yields because they thought the experience of the previous 20 years -- rising inflation and rising interest rates -- would go on forever, said Jim Grant, editor of Grant’s Interest Rate Observer newsletter in New York.
Similarly, bond buyers today are extrapolating the experience of the last 20 years -- declining inflation and declining rates -- out to the horizon, he said.
“I can’t help but view this moment as the mirror image of what we saw” in the early 1980s, Grant said. A bond buyer today, he said, is courting heartbreak.
Tom Petruno can be reached at tom.petruno@latimes.com.
