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 U.S. 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 U.K., by betting against gilts.
“When you look at the U.K., 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% of world gross domestic product in 2018 to an estimated 3.3% 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% this year to 9% of GDP.
“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 U.S. 10-year yield, is mired below 2%, and $11 trillion 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 U.S. 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 stabilize 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 U.K. isn’t an outlier -- Goldman Sachs Group Inc. strategist George Cole estimated that issuance to fund current spending and public-sector investment could be worth a boost of around 25-40 basis points in gilt yields next year.
Across the channel, ECB President Christine Lagarde is clearly taking up the push for more fiscal spending and may have more success than her predecessor. That said, expansive policy is emerging mainly in the peripheral countries, as a backlash against austerity. The region’s savers -- including its largest economy -- aren’t showing much sign of shifting their stance.
“We’ve seen this movie before,” said Brad Setser, senior fellow at the Council on Foreign Relations. “There is building pressure in Germany to increase investment and increase green investment in particular, but so far it hasn’t catalyzed an enormous shift in policy.”
In Japan, BNP Paribas SA sees increased government spending helping the 10-year yield edge up to +0.1% in 2020 from its current level just below zero.
But the Bank of Japan is scooping up bonds at such a rate, it’s still swamping fiscal efforts so far, according to UBS chief Japan economist Masamichi Adachi. This month’s $239 billion spending package may be only just enough to avert a recession following October’s sales-tax increase.
“The stimulus package isn’t a bold shift from the past and won’t significantly affect the outlook for markets or the Japanese economy,” Adachi said. “At most, it helps support confidence.”
But the rationale for higher yields is in place, at least in theory. S&P Global Ratings’ leading arbiter on the quality of the world’s government debt said that it’s gotten sketchier, as countries have seized on low interest rates to borrow more.
“You’re looking at close to 65 or 70% of world GDP that has today a lower credit quality than it had pre-2008 crisis,” said Roberto Sifon Arevalo. Government debt is “riskier today than it was before, but it’s not reflected in the market.”
Emerging markets have tended to pay a higher price for profligacy than developed economies with more room to spend, he said. And it’s worth remembering that when S&P cut the U.S.’s top-shelf credit rating, in 2011, Treasury yields plummeted as investors flooded into the world’s safest debt market. But the overall trend is clear.
“The market seems a bit complacent with the idea that interest rates will stay low for the foreseeable future,” said Sifon Arevalo.
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