Long-term bonds have become outcasts at the investor’s ball. Yields are very low, and prices – which move inversely – may appear to have nowhere to go but down. But could this oft-heard viewpoint be misplaced at this time of hyper-stimulative monetary and fiscal policies?
One of Wall Street’s best-performing fixed income fund managers certainly thinks so. And if the long-time bond bull is correct in his expectations for the direction of yields, it would translate into U.S. and Canadian bonds of longer durations delivering capital gains of between 15 per cent to 35 per cent over the next year or two. A bonus: Those stellar returns would be in addition to the bonds’ customary role of smoothing portfolio returns and providing a refuge when flight to safety becomes necessary owing to financial upheaval.
Long-term government bonds have been a disappointment so far in 2021. Their prices plunged over the first three months of this year, as inflation expectations shot upward in tandem with signs of a vigorous global economic upturn. But we have seen this movie before, and bond prices have already staged a modest rally so far this month – perhaps a hint of what’s to come.
Since the Great Financial Crisis of 2008, there have been similar periods of epic policy moves that triggered an economic surge. But after a quarter or two, the growth in gross domestic product faded away, bringing inflation expectations and bond yields back down. Indeed, the yield on 10-year U.S. treasury bonds has declined from 4 per cent in 2010 to 1.5 per cent currently.
Anyone who hung on to their long-term government bonds during the rounds of herculean pump priming scored big gains a year or two afterward, once the stimulus petered out. For example, the Wasatch-Hoisington U.S. Treasury Fund, which has an average duration of more than 20 years in government bonds, scored gains of 41.2 per cent, 32.6 per cent and 17.2 per cent in 2011, 2014 and 2018, respectively. The fund has US$447-million under administration and generated an average annual return of 7.9 per cent from inception in 1996 up to January, 2021.
The manager of the fund, Lacy Hunt, a former chief economist at a major global bank, continued to hold onto his long-term government bonds during the recent pick-up in the economy and inflationary expectations. He has just released the Hoisington Quarterly Review and Outlook for the first quarter of 2021, which provides his arguments for why the trend toward disinflation and declining bond yields should resume.
Several points are covered. But a key one is that many academic studies have found that high debt levels are a major drag on economies. “At the end of 2020, gross U.S. government debt reached a record 129.1 per cent of GDP, with new peaks reached in all major foreign countries,” Mr. Hunt notes. “The research indicates that the negative effect begins when gross government debt reaches 40 to 50 per cent of GDP.” Thus, fiscal policies, such as President Joe Biden’s US$2-trillion spending plan, may generate an initial boost but they add to government debt and contribute further to its disinflationary impact.
But isn’t monetary policy stimulative? True, the U.S. Federal Reserve, for example, is “buying U.S. government and mortgage-backed securities at the rate of $120 billion per month,” Mr. Hunt says. And this has injected a lot of money into the banking system. But it is not being lent out much to businesses because disinflationary environments cut into the demand for loans and shrink the spread between long-term and short-term interest rates, paring lending margins to the bone.
As for the new framework of allowing the annual inflation rate to go above their target of 2 per cent for a while, central banks hope to boost the spread between long-term and short-term interest rates. But in an interview, Mr. Hunt countered this notion, saying: “The central banks have been trying to bring inflation up to their 2-per-cent target for over a decade but have fallen short because of deflationary forces in the economy.”
Deflationary currents are also generated by countries competing against each other in global markets. After the Second World War the U.S. was quite dominant, but now Japan, Europe and China can produce products more efficiently in several industries, which idles capital and labour resources in the consuming countries and exerts downward pressures on domestic prices through competitively priced imports.
During the COVID-19 pandemic, “low-cost producers in Asia and elsewhere were unable to deliver as much product into the United States and other relatively higher cost countries,” Mr. Hunt points out. “As immunizations increase, supply chains will be gradually restored … and low-cost producers will want to regain market share.”
Where will bond yields end up? In an interview published on the Vance Crow Podcast, Mr. Hunt was of the opinion that the “entire treasury yield curve was going to press down on the zero bound and be stuck there.” This might seem unimaginable to some but it has already happened for 10-year government bonds in other countries, notably: Sweden (0.36 per cent), Spain (0.40 per cent), Japan (0.07 per cent), the Netherlands (-0.12 per cent), Germany (-0.26 per cent) and Belgium (0.05 per cent).
Even with 30-year government bonds, some countries are getting close to zero, including: France (0.84 per cent), Belgium (0.81 per cent), the Netherlands (0.35 per cent), Japan (0.64 per cent) and Germany (0.29 per cent).
If U.S. long-term government bond prices were to rally back to their 52-week high of last summer when the yield on 10-year Treasury bonds was down to 0.5 per cent, the Wasatch-Hoisington U.S. Treasury Fund would enjoy a capital gain of about 35 per cent. And if bond prices ever did appreciate to the point where yields fell close to zero, there would be a lot more in the way of capital gains.
In Canada, investors desiring bond exposure could consider Government of Canada long-term government bonds – or bond exchange-traded funds like the iShares Core CDN Long-Term Bond ETF (XLB), which holds federal and provincial government debt at an average duration of 15 years. Canadian bonds may not earn capital gains as great as bonds in the U.S., but if the benchmark 10-year Treasury bond falls back down to 0.5 per cent, it would still translate into at least capital gains of 15 per cent over the next year or two. And that would come without currency risk.
Finally, a caveat should be mentioned. Most central banks around the world are restricted by governing legislation to “lender of last resort” roles. But if the law is amended and/or the big central banks, such as the U.S. Federal Reserve, adopt a “spender of last resort” role, they will much more likely be able to generate an inflationary economy where bond yields climb upwards on a long-term basis and impose capital losses on investors.
Larry MacDonald can be reached at firstname.lastname@example.org
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