Time to Sell Bonds?
Richard Berner (New York)
Bonds are expensive in my view, and I think investors should lighten up to wait for better buying opportunities. Real yields are unsustainably low, complacency about inflation abounds, and many market participants believe — incorrectly in my opinion — that the Fed is nearly finished tightening monetary policy. However, there is some near-term risk that yields could dip slightly farther, reflecting so-called mortgage “convexity hedging.” And on both fundamental and technical grounds, the rebound in yields that I see coming from today’s too-low levels may not be immediate: Investors can still carry securities profitably, corporate borrowing is still muted, Asian official institutions are still accumulating dollar-denominated securities, and core inflation has recently declined.
But I think that most of the “technical factors” keeping yields low are in the price and that they will fade. More important, I believe that a coming change in perceptions about inflation and growth fundamentals will be catalysts to sell bonds. Given the ongoing nature of the rate debate, and the new conviction among many investors that yields won’t rise, it’s worth reviewing both sets of factors, the risks to being short, and where value in US debt might reemerge.
The first part of the debate revolves around the level of real yields. Real 10-year Treasury yields are 1½–2%, and the real federal funds rate is essentially zero; both are well below historical norms. Yet many investors suspect that the market is sending a message: We’re in a low-return world, and low real yields are just one aspect of that brave new paradigm. I’ve championed the idea that we are living in a world of single-digit returns for the past few years. But as I see it, even in that context, real interest rates are too low by any measure, given current economic and financial conditions.
In my view, real yields should be significantly higher than they are for two reasons. First, faster trend productivity growth is associated with higher returns on invested capital (ROIC) and higher profitability. Higher ROICs will tend to increased investment, boosting credit demand relative to supply, and thus real yields. And because I think trend productivity is 2½% or higher, real yields in my opinion should rise to 3% or more. Second, our chronic imbalance between investment and domestic saving also argues for higher real rates. That imbalance is most obvious in two bleak elements of the saving picture: Absent policy changes, I think cyclically-adjusted federal budget deficits are more likely to rise than fall from today’s 3.2% of GDP, and while I think personal saving rates will ultimately rise, they have persistently edged lower to today’s 1%.
But four factors are temporarily depressing real yields: A view that short-term rates won’t rise much, the return of the carry trade, low external financing needs, and Asian official institutions’ ongoing accumulation of dollar-denominated securities. In my view, at least the first three of those factors are poised to fade (see “Paradigm Shift?” Investment Perspectives, September 23, 2004). And if my colleague Steve Roach is correct, heavy Asian central bank buying of US securities may fade as they flinch from capping any increase in their currencies (see his accompanying dispatch, “Collision Course.”)
Inflation and inflation expectations are the second key part of the rate debate. Rising inflation fears contributed to the 110 basis-point jump in 10-year Treasury yields that began in late March. Now, in my view, investors are overly complacent about inflation risks. TIPS spreads and our fixed-income strategy team’s curve-embedded inflation indicator both suggest that markets are discounting roughly stable-to-lower core inflation. I still think inflation threats are mild, but whereas the market is now priced for slightly declining inflation, I see upside risks (see “Inflation: From Fear to Complacency,” Global Economic Forum, September 24, 2004).
Specifically, I think core inflation likely will rise to 2% or more, reflecting the three factors I’ve stressed for the last eighteen months. First, continued improvement in the balance between aggregate supply and demand, manifest in a narrower output gap and in rising operating rates, implies firmer pricing. The “output gap” has narrowed by more than a percentage point over the past year, to roughly 1½%, and factory operating rates excluding high-tech industries have jumped by more than 400 bp over the past 14 months. Second, monetary policy is still accommodative, evident in elevated inflation expectations and the lagged impact of the dollar’s decline on import prices. One-year-ahead median inflation expectations as measured in the University of Michigan’s monthly canvass are 30 bp higher than earlier this year. And the lagged impact of the dollar’s steep slide over the past 2½ years is now showing up in a reversal of earlier declines in import prices. Finally, unit labor likely rose at a 1.3% rate from a year ago in the third quarter — not high, but the fastest pace in three years.
To be sure, there are risks to being short for the immediate future, because the rebound in yields may not come quickly. Indeed, there is some risk that yields could decline even farther; so-called mortgage “convexity hedging” could accelerate as mortgage refinancing rebounds at levels slightly below today’s yields. According to Morgan Stanley mortgage expert Laurent Gauthier, up to 3/4 of securitized mortgages are refinanceable at 10-year yields below 3.85%. A temporary further dip might also occur as the Fed slows its pace of tightening, the carry trade is still in vogue, and investors stretch for yield. The fact that corporate borrowing is still muted, Asian official institutions are still accumulating dollar-denominated securities, and core inflation is still tame for the moment all could continue to cap the upside in yields for now.
Nonetheless, I think most of these factors are likely to change, and thus better bond-buying opportunities will emerge as Treasury yields rise towards 5%. Faster US economic growth and an upcreep in inflation will probably jolt the current consensus about monetary policy. Indeed, at the August FOMC meeting, officials pointedly reminded market participants that “significant cumulative policy tightening likely would be needed to foster conditions consistent with the Committee’s objectives for price stability and sustainable economic growth.” The coming acceleration in business credit demand that I see will likely herald a changed balance between US investment and saving and push up real yields. The unwinding of some carry trades likely will accelerate the process. And even at such yield levels, we’ll still be living in a world of single-digit returns.
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