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This article is an educational piece about the potential end to the decades-long bond bull market. For informational purposes only.
There has been much talk about the recent sharp rise in interest rates across the world, raising concerns that the decades-long bull run for bonds may finally be over. While interest rates have risen largely due to current high levels of inflation, this pressure is expected to gradually abate as fiscal impetus fades and supply-chains return to normalcy. Given that rates are rising from extremely low levels, every blip higher amplifies the move and attracts heightened attention.
Just because interest rates are low, it does not mean it will rise significantly and on a sustained basis. It is important to remind ourselves why interest rates are this low in the first place, and that many of the key drivers, such as debt levels, ageing demographics and deflationary pressure from disruptive technology are still with us today and will be in the foreseeable future. In the near-term, interest rates can be expected to rise further from here but eventually, these same structural forces will likely reassert themselves again to drive interest rates back down.
Bond yields tracking lower for decades
Since peaking in the early 1980s, interest rates have tracked lower and lower as crisis after crisis hit economies and markets. Driven by the fear of economic fallout and contagion, governments are compelled to enact bailouts while central banks are forced to cut rates. A quick look at the United States’ 10-year Treasury Yield shows this extremely consistent pattern of lower yields after each crisis over the past four decades.
Governments are now leading the global debt binge
The systematic response to every crisis has driven an incremental rise in global debt levels. According to the Institute of International Finance, the total global debt hit another all-time high in the second quarter of 2021 to USD296 trillion or 353% in debt-to-GDP ratio, driven by a massive USD36 trillion rise over 18 months from onset of the pandemic crisis¹.
Unlike the past where households or the corporate sector led the debt binge, governments have now taken over as the main drivers of debt growth. Since governments’ debts are now substantially larger than ever before, it is their prerogative to keep interest rates low to cap interest expense as minimal as possible. Higher interest expense could strain a government’s finances and lead to instability within its financial system which would negatively impact its economy.
This is where the central banks step in. They are responsible for monetary policies which support the economic and financial stability of their country, and one such policy is to keep interest rates low. Given that a debtor will always prefer the lowest borrowing rate possible, one can expect the trend of lower interest rates to continue.
US fiscal and monetary policies will be important
It is important to focus on US monetary policy since the US’ 10-year Treasury Yield is the global defacto risk-free rate for which all financial assets are priced against. Data by the Federal Reserve Bank of St. Louis shows that pandemic-related fiscal spending has driven the US government’s debt levels sharply higher to over USD$28 trillion or 125% in debt-to-GDP ratio² – a figure which will rise further with the passage of the USD$1.2 trillion infrastructure package and soon to be followed by the USD1.75 trillion “Build Back Better” spending plan³. This high debt-to-GDP ratio is a major concern as a study by the World Bank found that when this ratio exceeds 77% for prolonged periods of time, countries will experience significant slowdowns in economic growth⁴.
With the ever-growing mountain of debt, the US government can ill-afford interest rates to rise too high or else debt servicing will become a major issue. A sharper rise in interest rates could also stall the fragile recovery and drive the economy back towards recession, especially in one where consumer spending contributes a significant 70% of GDP, and higher interest rates tend to curtail consumption. A consumer-led recession in US consumption will also be felt globally as the US consumer market is by far the largest in the world⁵. And as history has shown us numerous times over the past decades, interest rates will fall when recession hits.
Debt burden to drive US on similar path as Japan and Europe
In the early 1990s following the bursting of the bubble in Japan, interest rates not only decreased but it went into negative territory as the Bank of Japan (BOJ) enacted quantitative easing (QE). QE is an unconventional monetary policy where the central bank purchases long-term securities from the market to boost money supply and lower interest rates to stoke economic activity and growth. After decades of QE which continues to this day, Japan is still combating anaemic growth and deflationary pressures resulting in a government deficit that currently stands at 266% in debt-to-GDP ratio – the highest among developed economies⁶.
Following the Global Financial Crisis and European Sovereign Crisis, this ultra-loose monetary policy and the immense build-up of debt has been copied by the European Central Bank (ECB) and European governments in 2015 in their fight against persistent stagnation and deflation, low-growth and low-inflation economy. And similar to Japan, these policies remain intact in Europe to this day, and both economies are stuck in a negative interest rate environment.
As the saying goes, “one is a once-off, two is a trend, three is a pattern”. It looks highly likely that the US will follow the same policy path as the BOJ and ECB because once one embarks on the path of debt binging, it becomes an addiction that is extremely difficult to wean off.
History is a great teacher
There are a few ways to address a massive debt problem. One can choose to either default, decrease, or defer the debt. For the US government, defaulting is out of the question and decreasing the debt would be a near impossibility as an austerity drive to cut spending will be required. Over the past two decades, the US government has spent much more than it earned and according to the US Congressional Budget Office’s forecast, it is likely this will continue over the next decade⁷. As history has shown us, any reduction in spending will likely lead to an economic contraction and the remedy is often even more debt-funded spending.
This leaves deferring the debt as the only viable option. All the US government needs to do is to continue servicing its debt obligations by ensuring interests due are paid. And the way to do this is to keep interest rates as low as possible and for as long as possible. This should be easy to do since the US Dollar is a leading global reserve currency (as are the Euro and Japanese Yen) and the US Federal Reserve can simply print more dollars and set interest rates accordingly.
“History is a great teacher” – since the least painful and most viable monetary policy going forward for both the US government and its central bank is to keep interest rates at ultra-low levels and possibly even negative (and can likely do so for decades as seen in Japan and Europe), the bond bull market is far from dead as ever lower bond yields will only drive bond prices higher.
About the writer
Prior to venturing into wealth advisory, Jamie was an equity sales trader for two decades covering global financial markets and servicing both institutional and retail clients. Having seen many market cycles, booms and busts, a key lesson that Jamie learnt is to never underestimate human ingenuity and its ability to adapt, improvise and overcome. Jamie hopes he can help to free the mind of others on the complexities and inter-connectedness of the financial markets, just like Morpheus in the Matrix movies.
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