The Japanese Government Bond Market
For many years, shorting the Japanese government bond market was called the “widowmaker” trade given that yields continued to fall despite the build-up in liabilities of the Japanese government. A key misunderstanding many investors had was the importance Japanese domestic savers placed on their own government bonds as a savings vehicle. Very low yields did not appear attractive to others in the developed world but weak growth and deflation provide attractive positive real returns to Japanese investors.
Volcker and Inflation
The relative stability of the Japanese government bond market was, for many years, seen as an oddity. However, the US government bond market after the 1970s should be reviewed to understand the wider reasons behind the start of the bull market. Following the oil price crises of the 1970s, central banks in the US and other Western European countries lost control of inflation. In essence, the ability to control inflation via post-war tactics was lost – especially as policy makers eventually abandoned the Bretton Woods system (which essentially tied currencies to the price of gold).
If one man can be credited as the author of the long rally in government bonds, it is Paul Volcker. Volcker was appointed US Federal Reserve (Fed) Chair in 1979 and is probably one of the most important central bankers in post-war history.
Unlike his predecessors at the Fed, he followed a far more aggressive monetary policy strategy. The inflation shocks from the 1970s oil crisis continued into the early 1980s, with US inflation peaking at 14.8% in March 1980. Volcker’s strategy was to push inflation out of the system by increasing interest rates. Looking at his track record, Volcker was extremely successful in bringing inflation under control, with inflation below 3% by 1983. The economic pain caused by high interest rates, however, was significant, with the Fed Funds rate peaking at 20% in 1981– with many attributing the 1980-82 recession to the Fed. Despite the pain felt in the bond market at the time, the policy demonstrated that a central bank was willing to control inflation – even if it caused a recession.
The Bond Market’s Golden Age
Over time, as many central banks adjusted their mandates to focus on inflation, bond market participants began to see government bonds as a safe investment. In the post-Volcker world, with inflation generally contained, government bonds began to be seen as a type of portfolio insurance. Government bonds could be used to dampen a portfolio’s downside risk as well as improve its risk adjusted return. As investors became increasingly confident that central banks would not allow inflation to get out of control, interest rates and bond yields slowly drifted lower. Despite occasional sell-offs caused by central bank policy tightening, bond investors understood that long-term inflation pressures remained under control.
In many ways the globally co-ordinated policy easing following the Great Financial Crisis (GFC) was the final lever of support for the bond market that started in the early 1980s. QE (Quantitative Easing), or central bank purchases of bonds, was tested by the Japanese central bank following the 1989-90 Japanese recession but had not been widely tested elsewhere. This changed following the GFC, with all the major central banks engaging in extensive government bond purchases as a form of unorthodox monetary policy. Despite government budget deficits widening, the supply of government bonds actually fell or remained stable as the central banks became a non-price sensitive buyer of bonds.
For long term investors, the rally has been extremely profitable with, for example, the US Treasury Index showing an annualised total return of 7.8% since the beginning of 1981. The UK Gilt index has a shorter track record but it has generated an annualised total return of 5.3% since the end of 1998. Given that investors in both the US and UK government bond markets are not taking credit risk, the returns generated can be viewed (in hindsight) as being very attractive.
In the post credit crunch world, one on-going concern for many economists is that growth in many developed countries has been tepid, with some forecasters suggesting that the US and Western European economies are in secular stagnation i.e. long-term low growth and inflation. The thesis around this view point is that the damage caused by the financial crisis has lowered the global economy’s trend rate of growth as financial institutions try to repair their balance sheets and consumers and companies become financially more cautious – with Japan being a prime example of what happens when a country enters secular stagnation. Following on from the 1989-90 recession, Japan suffered from more than 25 years of lost growth and very low price inflation.
The combination of low core inflation and very moderate wage growth over the past few years eventually led to bond yields hitting a fresh low in 2016 – as many investors believed the secular stagnation thesis was real. US Treasury yields remained low even when the Fed started to increase interest rates due to many market participants believing that the central bank would be constrained in its ability to raise interest rates with inflation remaining below the Fed’s 2% target. An additional factor that led many to believe that bond yields would remain low was the view that there remained a shortage of so-called safe assets due to a global glut of savings. Many investors were not looking for a return on their investment, rather just the return of their investment.
Global Growth synchronisation since late 2016
Since the fourth quarter of 2016, the outlook for the global economy has improved materially, with both growth and inflation ticking up. For example, the IMF forecasts global growth for 2018 and 2019 at 3.9%, the highest since 2011. With countries such as the US and UK experiencing nemployment rates below their expectations for full employment (e.g. the current US unemployment rate is 4.1% whilst the US Fed estimates a full employment rate of 4.6%), some economists are suggesting that inflation could return to the system, especially in the form of higher wages. Higher growth and inflation is leading central banks to start increasing interest rates (as in the US) or discuss an eventual finish to the QE programmes (as in Europe). At last, there are signs of an end to the bull markets in bonds, and core government bond yields have risen since the lows of 2016.
In conclusion, the post financial crisis rally in government bond prices has been supported by central banks buying government bonds. However as interest rates begin to normalise, bond yields have moved higher. The US Federal Reserve is slowly shrinking its balance sheet, with its share of US GDP having peaked in October 2014. Other central banks (e.g. the Bank of England and European Central Bank) are likely to follow the Fed’s lead and shrink their balance sheets over time. More fundamentally, many of the concerns over secular stagnation which have supported the bond market rally may turn out be more cyclical than structural.