Bedrock of ultra-low yields may be at risk

The new decade could be the dawn of a tougher era for bond investors, as conditions that sustained the historic bull run in government debt fall away.

Unprecedented central bank action has dominated economic stimulus since the global crisis and suppressed yields around the world. The skew may now be shifting more toward fiscal expansion that could pressure rates higher. Austerity is on the wane in Europe, spending packages are landing in Asia, and US borrowing is on track for even bigger records in the next couple of years.



The handoff from monetary to fiscal policy is a longer-run investment theme, says Mark Dowding at BlueBay Asset Management, and he's already trading it in the UK, by betting against gilts-.“When you look at the UK, what we're witnessing now is some pretty material easing in fiscal policy,” said Dowding. “It's a theme that we expect to see more broadly.”

The Organisation for Economic Cooperation and Development says government spending globally has helped widen the fiscal deficit from 2.9 per cent of world gross domestic product in 2018 to an estimated 3.3 per cent next year. Also, OECD economists are among the growing ranks pushing for more disbursements to tackle slowing global growth and climate change.

The trouble for investors is working out when government spending may reach a critical mass to push yields higher. As of now it's still in fledgling stages, while central banks continue to pump massive stimulus. “To me this is the story of the next decade,” said Elaine Stokes, portfolio manager at Loomis Sayles & Co. “The green shoots of fiscal spending are happening across the globe, but it hasn't gotten to a place where it is coordinated. “In the next 5 to 10 years it becomes a factor in markets,” Stokes said. “So that's where the market has to go -- we have to turn to a rising rate environment from a falling rate environment.”

The risk of a reversal in the last decade’s trend of falling yields is palpable. The governments of the two largest economies are spending more, and relying on debt to plug much of their revenue shortfall. Alicia Garcia-Herrero, chief economist for Asia Pacific at Natixis SA, sees China's issuance growing as the budget gap widens from 7.9 per cent this year to 9 per cent of GDP.

Ultra-low Yields at Risk

“Monetary policy has been less effective by itself, especially in the EU and China, the economy thus calls for more expansionary fiscal policy to grow,” said Garcia-Herrero, who previously worked for the European Central Bank and the International Monetary Fund. “One drawback of fiscal expansion is its upward pressure on interest rates.”

So far that pressure is barely registering in borrowing costs. The world’s benchmark, the US 10-year yield, is mired below 2 per cent, and $11trillion of debt worldwide yields less than zero. While that total has shrunk by more than a third since August — when global yields troughed — investors continue to seize on assets that offer some return. And it still looks way riskier to trade against haven flows and central bank purchases while the global economic outlook remains fragile.

That’s a popular and persuasive case against higher yields in the US for now, even as lawmakers on both sides of the aisle look ready to embrace blowout deficits. The Treasury may manage to keep borrowing steady this year — albeit at a record level — in part because the Federal Reserve’s current plan to stabilise short-term funding rates could trawl roughly $240 billion of bills out of the market in the coming months.

Investors like Dowding are focusing on regions where monetary policy looks most exhausted. He reckons the market is overestimating the likely stimulus from the Bank of England. And his call in the UK isn’t an outlier — Goldman Sachs Group Inc strategist George Cole estimated that issuance to fund current spending and publicsector investment could be worth a boost of around 25-40 basis points in gilt yields next year.