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July 14, 2016
The elephant in the room — Bond yields?
James W. Paulsen, Ph.D
Chief Investment Strategist,
Wells Capital Management, Inc.
The U.S. stock market has risen by more than 17% in the last five
months to an all-time record high immediately after a Brexit crisis
that many believed ensured a bear market. And yet, the elephant
in the room, the biggest question pondered today by investors, is
not about stocks but rather is “will bond yields ever bottom”?
The U.S. 10-year Treasury bond yield declined to an historic low last
week among several negative -- yielding international sovereign
bond yields. The slowest growing economic recovery in post-war
history combined with unprecedented and massive monetary
policies employed in concert about the globe have pushed bond
yields significantly lower than most anyone anticipated. Indeed,
they have fallen by so much for so long that calls for higher yields
have mostly gone silent.
Therefore, it is only with great trepidation of potentially being
premature (which most calls for a bottom in yields have been
throughout this recovery) that we suggest the current bond route
feels like a final blow off near its end. At this juncture, although
yields could certainly decline further, we think investors are best
served by preparing for an eventual period of rising yields.
Several factors are converging for the first time in this recovery
that may finally prove a formidable foe for bond yields. First, the
U.S. economic recovery has recently returned to some semblance
of full employment changing the interest rate dynamics from
earlier in the recovery. Second, the annual rate of core consumer
price inflation has begun to accelerate across the globe. Third,
for the first time, economic policy officials almost everywhere
are universally accommodative. Fourth, bond yields increasingly
and alarmingly appear divorced and disconnected from many
measures of economic activity (e.g., GDP growth, core inflation,
wages, loan growth and commodity prices). Finally, despite
mounting fundamental evidence that yields should be higher, calls
for imminently higher interest rates are almost nonexistent.
When a financial trend persists for so long and when its
magnitude becomes so overwhelmingly large, it begins to
feel normal. After years of periodic calls for higher yields, most
have simply given up and jumped on the “lower for longer”
bandwagon. But the Nifty-Fifty, oil prices, dot.com stocks or
house prices can’t rise forever and neither will bond prices.
We certainly do not know when bond yields will ultimately bottom.
However, it is worthwhile to consider just how much the sand
under the bond bull is changing.
A full employment recovery
Until recently, the economic recovery proceeded without creating
substantial pressure on bond yields because it exhibited so much
slack. High levels of unemployment allowed the economy to grow
without aggravating inflation or cost push pressures and therefore
without pressuring yields.
Chart 1
U.S. wage inflation and unemployment rate
Solid (left) — Annual U.S. wage inflation, six-month average
Dotted (right) — U.S. unemployment rate
Economic and Market Perspective | July 14, 2016
Now, as shown in Chart 1, even modest economic growth
may worsen yield pressures because the economy has finally
returned to some semblance of full employment. Until the
labor unemployment rate returned to about 5.5% in early 2015,
wage and core consumer price inflation were largely dormant in
this recovery. Since, however, for the first time in this recovery,
economic growth (even subpar economic growth) is forcing
labor costs (and core consumer price inflation, see Chart 2) higher
which ultimately will likely force a reset in U.S. yields.
A global rise in core inflation
A dramatic collapse in commodity prices in the last couple of
years has concealed the most significant and broad-based global
advance in “core inflation” yet in this recovery.
In the U.S. (Chart 2), the annual rate of core consumer price
inflation is currently close to its fastest pace of the recovery. In
Japan (Chart 3), despite concerns about weak economic growth,
core inflation has been running hotter since 2014. Similarly,
during the last year in Europe (Charts 4 and 5), the core inflation
rate has also turned higher. Although Canada certainly suffered
from the recent collapse in energy prices, as shown in Chart
6, core consumer price inflation recently rose to its highest
pace of the recovery. Finally, in China (Chart 7), while concerns
linger about slowing economic growth, core price inflation has
accelerated again since early 2015.
a different cycle. China (Chart 11) spent much of this recovery
attempting to moderate its expansion fearing overheat
conditions. As shown, bond yields in China trended mostly higher
in this recovery until mid-2014.
As they finally are today, policy officials have seldom been on
the same page simultaneously attempting to improve global
economic growth. Although the U.S. has been pushing upward
persistently, its efforts were often in conflict with less aggressive
or ambivalent Japanese actions (e.g., until the summer of 2013),
with outright tightening actions by the ECB (e.g., between 2010
until mid-2011 and again between mid-2013 to 2015) and with
the recovery moderating actions of Chinese officials.
Since the start of 2015, however, almost all global policy officials
are pushing upward on economic recoveries and therefore
creating the best chance yet that global yield structures may
finally trend higher. Simultaneously, long-term yields have
collapsed from the U.S. to the eurozone, Japan and China.
Moreover, the U.S. central bank balance sheet remains massive
and in the last couple years, bank balance sheets have also been
expanded in both the eurozone and in Japan. In short, for the
first time since this recovery began, policies across the globe are
synchronized in a collective effort to improve economic growth
and force yields higher.
Divergences defy logic
The eye-catching collapse in commodity prices since the
summer of 2014 certainly heighted concerns about deflation and
economic stagnation and these anxieties weighed on bond yields
about the globe. However, lost amongst the drama of a global
commodity price collapse was a U.S. economic recovery that
returned to full employment and a rise in global core inflation. As
the curtain closes on the recent commodity crisis, bond investors
and policy officials will be faced with rising commodity prices
“and” a core inflation rate that has already been rising without
fanfare for more than a year.
Policy officials are all pushing upward
Prior to the 2008 crisis, the 10-year U.S. Treasury yield was
between 4.5% to 5%. Even at the worst of the crisis in late-2008,
the 10-year yield briefly declined to only 2%. Despite beginning
the eighth year of this economic recovery, the current 10-year
yield is near an all-time record low more than 0.5% lower than at
any time during the 2008 crisis. That is, for an economy now in
expansion for more than seven years growing at about 2% with
a core consumer price inflation rate of 2.2% and a wage inflation
rate of 2.6%, a sub-1.5% 10-year bond yield appears ridiculous.
Increasingly, U.S. bond yields appear alarmingly divorced from
many measures of economic activity.
Charts 12 through 17 illustrate just a few examples of how “out
of whack” the U.S. yield structure is compared to historic norms.
Charts 12 and 13 show that the 10-year Treasury yield is currently
less than the core consumer price inflation rate and the wage
infla inflation rate. Indeed, relative to both of these traditional
inflation measures, the current 10-year yield has not been this low
in about 35 years!
For the first time in this recovery, “all” policy officials are
simultaneously stimulating the global recovery.
The U.S. adopted aggressively accommodative policies (Chart 8)
early and often in this recovery. As shown, annual growth in the
U.S. money supply is currently about 7%, twice as fast as nominal
GDP growth. However, Japan did not embrace full-scale central
bank easing (Chart 9) until about mid-2013. Eurozone officials
(Chart 10) initially tightened by implementing fiscal austerity
measures, did not expand the ECB balance sheet until late-2011,
and then reversed these actions between mid-2013 until 2015.
Finally, the emerging economic recovery has often been on
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Economic and Market Perspective | July 14, 2016
Chart 2
Chart 3
Chart 4
U.S. annual core consumer
price inflation rate
Japan annual core consumer
price inflation rate
Great Britain annual core
consumer price inflation rate
Chart 5
Chart 6
Chart 7
Eurozone annual core consumer
price inflation rate
Canada annual core consumer
price inflation rate
China annual core consumer
price inflation rate
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Economic and Market Perspective | July 14, 2016
Chart 8
Chart 9
U.S. M2 money supply growth
Annualized six-month rates
Japan central bank balance sheet — Total assets
Natual log scale
Chart 10
Chart 11
ECB central bank balance sheet — Total assets
Natural log scale
China 10-year government bond yield
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Economic and Market Perspective | July 14, 2016
Chart 12
Chart 13
Real 10-year Treasury bond yield*
*10-year yield less annual core consumer price inflation rate
10-year Treasury bond yield ralative to wage inflation*
*10-year yield less annual wage inflation rate
Chart 14
Chart 15
Real 10-year Treasury bond yield and commodity prices
Solid (left) — U.S. 10-year Treasury bond yield
Dotted (right) — JOC - ECRI Industrial Commodity Price Index
Treasury bond yield and nominal GDP growth
Solid — U.S. 10-year Treasury bond yield
Dotted — Trailing five-year annualized growth
in U.S. nominal GDP
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Economic and Market Perspective | July 14, 2016
While exhibiting a fairly close relationship to commodity price
movements throughout this recovery, Chart 14 shows that the
10-year yield failed to respond this year to a significant revival in
commodity prices. Chart 15 shows that the average annualized
growth in nominal GDP relative to bond yields has widened to
its largest divergence of this recovery and one of the largest
divergences since 1960. Chart 16 illustrates a breakdown in
the last couple of years between bond yields and measures of
economic confidence. Currently, while consumer confidence
is close to one of its highest levels of this recovery, bond yields
have collapsed to record lows.
Finally, Chart 17 shows a recent break in the close relationship
between yield movements and corporate yield spreads. Since
at least 2000, corporate yield spreads have oscillated closely
with the direction of the 10-year Treasury yield. Specifically,
corporate spreads have usually tightened when yields have
risen and widened as yields have fallen. However, since early
this year, corporate spreads have tightened despite much lower
Treasury bond yields. That is, for the first time in this recovery,
the messages coming from within the bond market itself seem
conflicted. Lower Treasury bond yields seem to suggest rising
anxieties surrounding economic growth and deflation whereas
tighter corporate bond yield spreads simultaneously suggest
rising confidence in financial strength, corporate earnings results
and the durability of the overall recovery.
These examples are not an exhaustive list of the broken historic
relationships traditionally tying the yield structure to the overall
economy. For example, the 10-year yield has declined by about
1% in the last year despite U.S. bank loan growth rising by almost
8% to its fastest pace of the recovery. Additionally, the trailing
12-month earnings yield on the U.S. stock market is currently at
one of its widest spreads relative to the 10-year Treasury yield in
the post-war era.
Chart 16
Confidence and real Treasury bond yield
Chart 17
Treasury yield and corporate bond yield spread
Solid (left) — U.S. 10-year Treasury bond yield
Dotted (right) — Chase high yield bond spread, inverted
scale
in U.S. nominal GDP
Breaks in the traditional relationships between Treasury yields
and economic performance are both numerous and extreme
today. Importantly, this was not the case until recently. Earlier in
this recovery, the 10-year yield was 1% to 2% above the rates of
wage and core inflation (Charts 12 and 13). It wasn’t until 2014
that the spread between nominal GDP growth and the 10-year
yield became extreme (Chart 15). Confidence measures and bond
yields began to diverge only since 2014 (Chart 16). Moreover,
until recently, loan growth remained very modest consistent with
very low yields. Finally, it wasn’t until this year that the 10-year
yield disconnected from both commodity prices and corporate
bond yield spreads (Charts 14 and 17).
Bottom line? Unlike earlier in this recovery, the U.S. yield structure
appears increasingly disconnected from and unsustainably low
relative to the underlying performance of the economy.
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Economic and Market Perspective | July 14, 2016
Chart 18
Chart 19
U.S. 10-year government bond yield
Source: Shiller and Bloomberg
S&P 500 Dividend Aristocrats Index relative total return
vs. 10-year U.S. Treasury bond yield
Solid (left) — S&P 500 Dividend Aristocrats Relative Total Return Index
Dotted (right) — 10-year U.S. Treasury bond yield, inverted scale
A mantra of “lower for longer”
U.S. bond yields have been in a downward trend for more than
35 years and have fallen to levels almost nobody expected during
this recovery. However, persistence in a trend is probably the
primary ingredient in a consensus belief. And now, after years of
periodic calls for higher yields, most have simply given up and
jumped on the “lower for longer” bandwagon. Indeed, even the
Federal Reserve seems to have recently adopted this mantra.
Chart 18 is a good reminder of just how silly the current yield
structure in the U.S. appears. Currently, the 10-year yield is near
an all-time low dating back to 1870! Today, more people are
employed in this country than ever before, the unemployment
rate is lower than about 72% of the time since WWII, nominal
GDP is about 25% higher than at the end of the last expansion,
disposable personal income is almost 30% higher, household
net worth is 30% higher, core consumer price inflation and
wage inflation are between 2% and 2.6%, the annual auto sales
rate in the U.S. is near an all-time record, bank lending is up
by 8% in the last year, corporate profits are almost 15% above
peak levels in the last recovery, the stock market is at an all-time
record high and the current economic recovery is now the third
longest on record.
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With this as a backdrop, does it make sense that the 10-year
Treasury bond yield is currently lower than it was at any point
during the entire Great Depression?
Bond blow-off in the stock market?
Stock investors should take note of just how much the
bond bull has infiltrated the stock market and perhaps take
appropriate defensive action.
Chart 19 overlays the relative performance of a popular stock
index with bond yields. The solid line shows the relative total
return performance of the S&P 500 Dividend Aristocrats Index
(relative to the overall S&P 500 Index). This index measures the
performance of the S&P 500 constituents that have followed a
policy of consistently increasing dividends every year for at least
25 consecutive years. Essentially, this index captures the most
high quality bond-like stocks within the S&P 500 Index.
Economic and Market Perspective | July 14, 2016
Chart 20
Chart 21
S&P 500 Utilities Index relative total return
vs. 10-year U.S. Treasury bond yield
Solid (left) — S&P 500 Utilities Index relative total return
Dotted (right) — 10-year U.S. Treasury bond yield, inverted
scale
S&P 500 Consumer Staples Index relative total return
vs. 10-year U.S. Treasury bond yield
Solid (left) — S&P 500 Consumer Staples Index
Dotted (right) — 10-year U.S. Treasury bond yield, inverted
scale
Chart 22
Chart 23
Dow Jones REIT Index relative total return
vs. 10-year U.S. Treasury bond yield
Solid (left) — Equal-weighted relative total index comparing
S&P 500 financials, energy, and industrial sectors
Dotted (right) — 10-year U.S. Treasury bond yield, inverted
scale
S&P 500 Anti-bond Dividend Index* relative total return
vs. 10-year U.S. Treasury bond yield
Solid (left) — Equal-weighted relative total index comparing S&P
500 financials, energy, and industrial sectors
Dotted (right) — 10-year U.S. Treasury bond yield
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Economic and Market Perspective | July 14, 2016
As shown, the performance of bond-like stocks has followed the
bond market very closely since 2000 (the dotted line is the 10-year
Treasury bond yield on an inverted scale). Many investors have
adopted equity portfolios comprising stocks similar to those in
the Dividend Aristocrats Index — high quality, premium dividend
payers with steady profitability. Three of the most popular stock
sectors possessing these preferred characteristics are utilities, real
estate investment trusts and consumer staples. Charts 20, 21 and
22 show that the superior relative total return performances of
each of these sectors have been strongly tied to a trend of lower
bond yields.
Investors should consider lightening up on bond-like sectors
and consider overweighting some “anti-bond” sectors. Chart
23 provides an illustration of three sectors that have exhibited
a propensity to outperform during periods of rising yields. The
solid line is an equal weighted relative total return index for the
S&P 500 financials, energy and industrials sectors. Between 2000
and 2002, this index outpaced the overall S&P 500 Index despite
falling yields but this was primarily because all sectors outside
of technology stocks outperformed during the initial stages of
the dot.com market collapse. Since 2002, however, the relative
performance of these three sectors has been closely tied to the
direction of bond yields. Should bond yields trend higher, these
sectors should outpace the highly popular bond-like stocks.
Whether global policy officials are artificially pegging U.S. yields
at low levels or whether these yields simply reflect widespread
global fears among private investors, the current U.S. yield
structure appears increasingly unsustainable.
Written by James W. Paulsen, Ph.D.
An investment management industry professional since 1983, Jim is
nationally recognized for his views on the economy and frequently
appears on several CNBC and Bloomberg Television programs, including
regular appearances as a guest host on CNBC. BusinessWeek named him
Top Economic Forecaster, and BondWeek twice named him Interest Rate
Forecaster of the Year. For more than 30 years, Jim has published his
own commentary assessing economic and market trends through his
newsletter, Economic and Market Perspective, which was named one of
“101 Things Every Investor Should Know” by Money magazine.
Summary and conclusions
Who knows when U.S. bond yields will ultimately bottom? In
our view, however, investors should prepare for an upward
trend in yields during the balance of this recovery. This should
include examining the allocation of the portfolio between
stocks and bonds, the duration and quality exposures within
the fixed-income segment and the sector weightings employed
in the stock allocation.
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