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A Never-ending Bull Market for Bonds

Market observers have been calling the end to the decades-long bull market in U.S. Treasurys for years now. They’ve been wrong.

For the past several years, analysts have sounded the death knell for the great bond market rally that began way back in 1981, only to be repeatedly confounded.

While 10-year Treasury notes may not return to last July’s record low yield of 1.36 percent, they have remained range-bound for the last five months. This despite an improving economic picture for the U.S., continually higher equity markets and the Federal Reserve serving up (in fits and starts, anyway) a gradual tightening in the Fed funds rate.

So what would it take to generate a definitive end to the bond bull market? In a word, inflation, analysts and money managers say. Despite the long-era of loose money policies and quantitative easing after the financial crisis, inflation has been stubbornly modest.

“There is a connection between interest rates and inflation,” says Martin Fridson, chief investment officer at money management firm Lehmann Livian Fridson Advisors in New York. “I don’t think interest rates will rise significantly until inflation expectations rise.”

Inflation expectations came in at just 1.8 percent May 3, as measured by the spread between Treasury inflation-protected security (TIPS) yields and regular Treasury yields, he notes. In fact, the consumer price index has rarely registered year-on-year increases of more than 2 percent over the past nine years.

“It began with [former Federal Reserve Chairman] Paul Volcker reining in inflation in the early 1980s,” Fridson says. “We’ve pretty much been on track since then, with brief periods of deflation.”

Many analysts expected that the Fed’s massive easing campaign in response to the 2008 financial crisis would reverse that trend. But while the supply of money has increased, money supply velocity has “fallen off a cliff,” Fridson says. Meanwhile, shrinking Chinese demand for commodities and the explosion of U.S. shale oil and gas production put downward pressure on commodity prices. Additionally, wage gains have been limited by outsourcing and automation.

Michael Hartnett, chief investment strategist at BofA Merrill Lynch Global Research, says the three “Ds” have helped keep inflation under control. That includes demographics, an aging population less inclined to spend and more inclined to save; high debt, which discourages consumers and businesses from spending as they seek to prune that burden and technological disruption, which has lowered costs for consumers and businesses alike.

What we are witnessing now is a “battle between secular deflation, [caused largely by those three factors] and cyclical inflation,” Hartnett says. So far, that has meant bond yields trading higher than last summer’s low but without a real trend.

“To generate a real bear market, that cyclical inflation must become stickier,” he says. “The only way that happens is through wages.” By that gauge, we shouldn’t count on any severe trouble for bonds soon; average hourly earnings rose just 2.5 percent in the 12 months through April.

The Federal Reserve has a role to play too, analysts and money managers agree. A combination of Fed rate hikes and an economy strong enough to boost inflation could push yields higher, though a raging bear market is certainly unlikely, says Andrew Goodale, a portfolio manager for diversified fixed Income at Eaton Vance.

“If the Fed consistently hikes rates, I think people will look to re-evaluate their bond holdings,” he says. Inflation plays a role, both on the wage and commodity side, he says. “But I think the real trigger will be the Fed moving a few more times. If it (raises rates) two more times this year, I think we’ll begin to see questions asked that haven’t been asked yet.” The Fed has increased rates only once so far this year, in March, following the lone rate hike of 2016 in December.

Foreign factors play a role too. “Why are Treasury yields so low? Because of bunds, Japanese bonds, etc.” Hartnett says. Many foreign bonds have sported negative yields at times over the past year, driving global investors to the higher yields in the U.S. market. Those foreign purchases of U.S. bonds suppress U.S. yields.

Stronger economic growth in Europe and Japan is necessary to push U.S. yields higher, Hartnett says. Manufacturing already is rebounding in both areas, but consumers need to follow suit.

A cyclical global recovery is underway now and will strengthen enough to send bond yields higher for the next two to three quarters, he maintains. “If that causes a synchronized global central bank tightening, we could see a large rise in yields,” Hartnett says. “But when I look out two to three years, I find it difficult to see Japan or Europe getting out of first or second gear. So it will be difficult for global inflation and yields to trend significantly higher.”

Japan’s deflationary psychology is so strong and its population aging so quickly, that it “has forgotten how to grow,” Hartnett says. And Europe is still having trouble “unlocking” productivity and innovation. Thus, he sees only a “slow motion, cyclical end to the bond bull market.”

Fridson sees several ways that inflationary expectations could jump, spelling doom for the bond market. One would be a lasting surge in oil or food prices, “something that is not just a statistical aberration for a month or two and signals something is changing in the economy,” he says.

A second possibility would be an increase in capacity utilization, which has been hovering around 75 percent (76.1 percent in March), to over 83 percent, Fridson says. “If companies continue not to expand and demand caught up to send capital utilization to the low to mid-80s,” companies could raise prices, he says. Or if money velocity grew as money supply has, that could create inflation, Fridson says.

But none of this is likely soon, he maintains. “Demand is soft, which means it’s difficult for companies to raise prices. I can’t see anything imminent pointing to a spike in inflation.”

The 10-year Treasury yield is unlikely to return to July’s 1.36 percent level, he says. But nothing on the horizon points to a substantial increase in yields either. “Given the warp of history, it’s likely that sometime in the 10 years, rates will be significantly higher than today. But now it’s pure speculation as to what will cause it.”

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