As monetary tools reach their limits, calls for sustained fiscal stimulus are growing. While conventional thinking would assume that this environment would negatively impact bond investors, Sajiv Vaid challenges this view and outlines why he believes low yields are here to stay irrespective of the prevailing fiscal policy stance.
Key points
- Markets don’t always react in the way textbooks tell us and we may be approaching one of these moments.
- Economic theory would tell us that the inflationary impact of fiscal stimulus would negatively impact bond holders, but this may not be the case.
- We believe there are powerful structural and cyclical factors that will keep yields low even if we see a meaningful shift in fiscal policy going forward.
Since the global financial crisis, policy makers across the world have embarked on an extraordinary monetary experiment in an attempt to stimulate their economies. But despite central banks’ best efforts, growth and inflation have remained stubbornly muted. In addition, growing inequality within nations has triggered a populist backlash that is both anti-globalisation and anti-establishment. As a result, governments are contemplating fiscal stimulus - a more conventional form of policy designed to lift growth and inflation and appease their electorates.
The classic response from investors to a jump in fiscal spending is to become cautious on bonds. Economic theory dictates that fiscal largesse leads to a rise in growth and inflation, and scrutiny from ‘bond vigilantes’ as government balance sheets deteriorate. This in turn leads to a sell-off in bonds and fears of a bear market and renewed calls of an end to the multi-decade bull run. However, we see a different scenario playing out as fiscal purse strings are loosened. We think bond yields will remain low and range-bound and developed markets will continue down the ‘lower for longer’ path.
Central banks help keep borrowing costs low
For governments to spend sustainably, nominal GDP growth must remain higher than nominal yields so that government debt-to-GDP falls over time. Central banks can facilitate this process by using a number of tools to suppress nominal yields (the government’s cost of borrowing), including quantitative easing, yield-curve control or financial repression strategies that reduce borrowing costs.
Bond yields have fallen below growth rates
Source: Fidelity International, Bloomberg, September 2019.
Downward pressure on yields to continue
Given the support to bond prices from central banks and the late-cycle environment, we are comfortable holders of duration. Duration provides both income and diversification away from stocks, and if market sentiment switches from risk-on to risk-off, investors will flock to government bonds and high-quality credit at a time when there is a shortage of safe-haven assets. The result will be downward pressure on yields, supporting bond returns.
We don’t rule out temporary rises in yields, but they’re likely to be short-lived and limited in upside. It is clear that the financial system is unable to sustain high debt levels with high financing costs; examples of this occurred during the ‘Taper Tantrum’ in 2013 and the wobble in 2018 when the US economy and global risk assets revealed their vulnerability to rising yields. On both occasions, 10-year US Treasury yields breached the key psychological threshold of 3% before tumbling to new record lows.
Each peak and trough in yields is getting lower and lower, and negative yields have highlighted there is currently no floor for this structural trend. I do not see any change to this on the horizon, even as fiscal policy returns.
This information is for investment professionals only and should not be relied upon by private investors. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. Changes in currency exchange rates may affect the value of investments in overseas markets. The value of bonds is influenced by movements in interest rates and bond yields. If interest rates and so bond yields rise, bond prices tend to fall, and vice versa. The price of bonds with a longer lifetime until maturity is generally more sensitive to interest rate movements than those with a shorter lifetime to maturity. The risk of default is based on the issuers ability to make interest payments and to repay the loan at maturity. Default risk may therefore vary between government issuers as well as between different corporate issuers. Reference in this document to specific securities should not be interpreted as a recommendation to buy or sell these securities, but is included for the purposes of illustration only.
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