The AMP’s chief economist, Dr Shane Oliver says there is a distinct cloud hanging over the return outlook for government bonds in many advanced countries, but not Australia.
Government bonds were the star performer in 2008 when economic growth collapsed, central banks slashed short term interest rates and investors rushed into bonds as a safe haven, thereby pushing down their yields and resulting in capital gains for investors.
Looking forward, their outlook is clouded by low starting point yields, the prospect that short term interest rates will start to rise and the risk that when private sector borrowing picks up the competition between the public and private sectors for funds will result in rising bond yields.
While a US double dip back into recession may help sovereign bonds, it can be just as easily argued a looming fiscal crisis at some point down the track is a much bigger threat if investors lose patience with the pace of improvement in budget deficits.
Low yields
Sovereign bond yields were pushed sharply lower through the dark times of the global financial crisis.
While bond yields have risen from their lows they still remain relatively low in the US, Europe and Japan, despite all the concerns about high budget deficits and sovereign debt.
The still low level of bond yields reflects a range of factors:
Inflation is low with core inflation rates still falling in most developed countries.
Short term rates are near zero in the US, Europe and Japan and are expected to remain low for an “extended period”.
Private sector borrowing is still depressed, so the public sector has little competition for funds.
Banks in the US and elsewhere have been buying government bonds (borrowing from central banks at near zero interest rates and investing in higher yielding government bonds to rebuild their balance sheets).
US mutual fund data shows US retail investors have been piling into bond funds. Last year a record $US390bn flowed into bond mutual funds, whereas US equity mutual funds saw a modest outflow.
Bond fund inflows have remained strong so far this year.
Quite clearly, investors are still very cautious of shares, preferring the yield (albeit low) on offer from bonds.
Finally, while bond yields have been pushed up in countries perceived to have excessive public debt levels and a perceived greater risk of default – Greece being the prime example – core advanced countries may have actually benefitted from a flight to safety.
For the immediate future we don’t see a big change: inflation is likely to remain low in advanced countries reflecting high levels of unemployment and very low capacity utilisation rates; the start of interest rate hikes in the US, Europe and Japan is still some way off and private sector borrowing will take a while to recover.
Low level bear market in government bonds
However, short of an extended outbreak of deflation, on a medium to longer term basis it is hard to be optimistic on the outlook for government bond returns in advanced countries for the following reasons:
First, starting point yields are very low suggesting that even if yields are unchanged at current levels returns will be low.
Second, bond yields in the US, Europe and Japan are arguably below the levels that can be justified on a long term basis.
Over the long term there is a rough relationship between bond yields and long term nominal economic growth
The following table looks at current ten year bond yields relative to our assessment of their long term value based on their potential nominal GDP growth.
While those in the UK and Australia are around fair value, those in the US, Germany and Japan are well below.
Third, sometime in the next six to nine months investors will start to factor in higher short term interest rates in key advanced countries and this will likely see longer term bond yields pushed upwards.
Fourth, as the global recovery gathers pace private sector borrowing will rise.
If budget deficits are not reduced substantially this will result in an increase in competition for funds and hence higher bond yields.
This will be magnified if banks regain confidence in lending to the private sector and so cut their investment in government bonds at the same time.
Fifth, when confidence is regained in the sustainability of the economic recovery in advanced countries it is likely investors will start to switch away from bonds into shares.
Given the amount of money that has flowed into US bond funds over the last year this is a real risk factor for US bond yields.
The big question is when will confidence in the sustainability of the economic recovery in the US take a turn for the better?
The key is likely to be employment. Many super bears have hung their view on poor employment, hence arguing the US recovery won’t be sustainable once the impact of government stimulus ends.
However, a range of indicators are now suggesting US employment will start rising again sometime in the next few months: unemployment clai
