The word is out from the Fed: are going up. We all knew this, but the unfounded recession fears that briefly possessed market participants earlier this year made us forget it for a little while. However, as we noted last week, signals from the Fed have been strong.
Yes, the situation the Fed faces is difficult, not to say perilous. Yes, there are complicating aspects to the global macro backdrop, such as the need for the People’s Bank of China to maintain the stability of the , which is linked to the . However, when we survey the broad picture, we can see clearly that we are at the end of a more-than-30-year period of declining yields. And when we listen to the message being sent out by the Fed, it is clear that they are preparing us for higher rates.
Rates have been extraordinarily low for an extraordinarily long time. The ZIRP policy of the Fed and the NIRP (negative interest rate) policy of other central banks have, in turn, put extraordinary pressure on investors, both individual and institutional, who need reliable yields for income or to fund liabilities.
Sure Looks Like the End of a Cycle to Us
Source: Federal Reserve Bank of St Louis
These investors have been pushed into higher-risk assets. Typically we think of higher allocations, perhaps to dividend-paying stocks, as examples of such assets. But investors have also “reached for yield” by reaching far out into the future of bond maturities. This “reach for duration” is also a push into areas of higher risk, and this is the case even with supposedly “rock-solid” investments such as government bonds.
Bond mathematics means that the further out in the future a bond’s maturity date, the more rapidly the capital value of the bond declines as interest rates rise (bond prices and yields are inversely related). So although the governments of Germany and the United States, for example, are extremely good credit risks (they are extremely unlikely to default) that does not affect the grave duration risk posed by their longer-dated securities.
Data Source: The Wall Street Journal
The chart above shows how the value of bonds declines in response to rising interest rates. A 3% rise in yields — from about 2.5% to about 5.5% — would cause a 43% decline in the value of a 30-year bond. We don’t believe that such a rise is imminent or would happen quickly; this is more a mathematical demonstration of how bonds react to rising yields. We anticipate a 1% or greater rise in yields over the next two years.
Perhaps investors will comfort themselves by thinking that they will be holding bonds to maturity — but who can say what events in their life might require some or all of a bond portfolio to be liquidated long before such a distant date?
French, German, and Japanese bonds with 40- and 50-year maturities are being sold to investors… to us, this is little different from legalized theft. Perhaps some holders of German bunds, who saw their value drop 25% in one two-month period last year, might agree.
Don’t Lose the Forest for the Trees
Once again, we note: when we step back and look at the long view, we are at the end of a cycle. The 30-year bull market in bonds driven by that cycle is coming to an end. We believe reaching for yield by buying long-dated bonds now, is buying at an historic peak. Buying any asset at such a peak is asking for losses that will likely never be made whole.
We do not believe that low rates are the harbinger of a coming global depression; we believe they have been engineered by the world’s central banks in an attempt to fight the lingering deflationary impulse of the financial crisis, support asset prices, and spur economic growth. (For a variety of reasons, including over-indebtedness and excessive regulation, they have not succeeded as well in this effort as they might have.) There is a lower bound to rates; we have reached it; and the rise from that bottom is inevitable, although we do not know how rapid it may be.
Perhaps the troubles faced by the global economy — the over-indebtedness and over-regulation that we mentioned above, as well as demographic challenges in some countries — may mean a prolonged period of tepid growth and low rates. Even so, holders of long-dated bonds will be fighting against a receding tide as they watch the value of their bond portfolios.
This is not to say that further extraordinary measures will not be tried by the world’s central banks before all is said and done; we suspect they are not even close to having brought out their really heavy artillery. But the message is clear: safe bonds are not safe, if “safety” includes any thought of preserving your capital.
Investment implications: Equities are not the only risk assets. As we stand near the end of a 30-year credit cycle, bond yields are poised to rise. We don’t know how fast — that depends on many factors affecting the global economy — but the writing is on the wall. Bond math means that the longer the maturity, the greater the risk to investors’ capital posed by rising yields. Although some government bonds may be excellent credit risks, they can still be very unattractive duration risks; holders of long-dated bonds will be fighting against a receding tide. We continue to suggest that investors avoid bonds, or, if they must hold them, that they shorten the duration of their portfolio to reduce the capital risks posed by rising rates. If you need income, consider stocks with strong and growing dividends over bonds.