The end of the bond market bull run

For more than 40 years betting on developed-country sovereign bonds has required following one simple rule: rates will go lower. US 10-year Treasury yields peaked at around 16 per cent in 1981 and have, with only brief interruptions, been steadily falling ever since, reaching close to 0.5 per cent during the most acute phase of the pandemic. Bond prices rise as yields fall, and so the decline in long-term interest rates delivered a substantial windfall to bondholders.

Predictions of a reversal in this trend have frequently come to naught — investors have periodically asked how interest can possibly go lower, only for rates to plumb new depths. Yet this time the multi-decade investment trend may really, finally, be coming to an end. Despite a small rally, this week could mark the end of the bond bull run as central banks begin the long, slow tightening cycle and the long-awaited “normalisation” of monetary policy. If it does not, then policymakers have even more reason to worry as it would probably indicate that the rich world is stuck with low inflation and low growth.

The world’s most important central bank, the Fed, announced that it would begin to taper its pandemic asset purchase programme, joining the central banks of New Zealand, Norway, Canada and Australia in all beginning to limit monetary stimulus after the pandemic largesse. While the Bank of England confounded investors betting on a rate rise at Thursday’s meeting, there is widespread expectation of a small increase next month. Emerging markets have tightened even more aggressively: on Wednesday the Polish central bank increased rates by 75 basis points, its second rise in two months.

So far the effect on US bond markets has been limited, as the Fed, rightly, indicated that any future rate rises would be gradual and the shift to a more “normal” stance slow; it will this month reduce the pace of quantitative easing asset purchases rather than ceasing them altogether. In Australia, rates on the country’s 10-year debt reached the highest level in two years after the central bank stopped defending its yield target for bonds maturing in April 2024. Even that, however, still left them close to historic lows. Indeed, the three anglophone banks that made policy announcements this week — the Fed, the BoE and the Reserve Bank of Australia — all pushed back against market expectations that there would be a rapid tightening of policy to combat inflation.

Traders and central bankers alike are understandably cautious that the more fundamental trends behind the slowdown have not gone away, whether technological change, globalisation or the ageing of western societies. But that is an argument for long-term rates to stay relatively low, even in more normal times, and not for them to fall further: none of these factors became any more deflationary during the pandemic. In fact, China’s changing role in the global economy is potentially reducing one source of disinflationary pressure. Overall, the bull case for bonds, now, is the bear case for the rest of the world — this week’s shifts in monetary policy reflect a relatively robust recovery from the pandemic.

There is a more unhappy way that the bull market could end, however. If central banks lose control of inflation expectations, instead of keeping them anchored around their targets, interest rates would end up rising without reflecting an improvement in the rich world’s growth prospects. Real rates — after adjusting for the effect of inflation — would remain low even as central banks’ policy rates rise. For that reason, bond traders, along with the rest of us, should hope that central banks can “normalise” for the right reasons.

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