Government bond yields across developed markets are low by historical standards. Monetary policies have been a major driver whilst the situation in the UK has been exacerbated post the Brexit referendum. Yields have recovered in the last few months and inched closer to pre-Brexit levels but the market continues to be pricing in a lower for longer story.
The Market Forecast Group (MFG) of JLT believes that yields may rise faster than priced in by the bond markets. In this paper we explain our thoughts on the longer term levels of gilt yields.
On A Downward Spiral
UK government bond yields have had a long downslide over the last thirty years. Nominal yields (the implied annualised return that will be received by holding the asset until maturity) on gilts of ten year maturities, which were at around 13% in the early 1990s, now quote around 1.5%.
UK 10Y Nominal Gilt Yield (%)
Lower yields mean lower future returns, so put another way, UK government bonds have become comparatively more expensive over the last thirty years.
The Humped Uk Sovereign Yield Curve
Source: Risk First PFaroe
Whilst the UK yield curve has flattened considerably over the last year (see chart below), investors still receive a higher yield for investing over medium maturities as compared to longer maturities. This is referred to as an “inverted” yield curve. Inversion has historically been an indicator of future recessions, however, whilst we are closely monitoring this unusual hump, we are not forecasting a recession as being on the horizon.
Simply speaking the current curve implies that, although investors require a risk premium for medium term maturity bonds over shorter term bonds, they are ambivalent about the longer term.
Source: BoEPart of this is attributable to higher demand for longer dated gilts, for matching purposes by pension funds and insurance companies.
Looking at forward curves (what current bond prices say about future yield curves), it suggests that this inversion will last for many years, as shown in the right chart.
This implies that current yields are pricing in a decade long recessionary condition. It is imperative to mention here that forward curves are only a reflection of current pricing rather than explicit expectations. Pricing generally adjusts to more realistic levels as the markets get further clarity with the progress of time. So, actual yield curves in the future could look very different to those shown below.
The Real Rate Conundrum
Uncovering long-run trends in real rates (the yield after inflation) is tricky, views differ and there’s no economic law that says that rates will move to the average price over time.
However when we look at past data, the 5-year average of the real bank rate rarely goes below zero, as shown on the chart on the following page – rare examples of where it has are during the 1970s inflation and around the World Wars.
The decline in real bond yields since the 1980s leaves them about 300 basis points (3%) below their all-time average.
Real Rate Over Time
Whilst a return to the historic average requires the Bank Rate to rise by about 200 - 450bps (2% - 4.5%), much more than the yield curve currently suggests, there are several factors that do support a lesser rise in real rates:
We expect some relationship between GDP growth and yields. Based on current growth rates, yields are low, in fact in the bottom 15% of observed outcomes for this level of GDP. When this level has been breached in the past, we have seen a quick reversion towards more normal levels. Clearly though the demand for gilts is having an impact.
With the UK economy having recently recorded a 42 year low unemployment rate, the BoE expects a tightening labour market and therefore a gradual acceleration of wage growth in the near term. This underpins our forecasts that further Bank Rate increases are likely over the coming years, which will put pressure on longer term rates to increase too.
Technological advancements sees companies generate a greater output per unit of labour resulting in an expectation of improvement of potential GDP.
Conventional GDP statistics may understate the importance of technological changes in current productivity measures, thereby suppressing expectations of long term real interest rates.
An ageing global population and a slowdown in global population growth is likely to result in both savings and investments to fall with savings falling faster than investments, thereby resulting in a rise in real yields.
Higher proportions of dependents are inflationary, and it is only the working cohort that can be deflationary for an economy. This is because, both young and old are net consumers and it is only the working cohort that can offset the demand for goods and services through production. Over the next few decades, when the rate of growth of dependents outstrips that of workers, we would expect inflation to rise.
What Can Dampen Yields?
So far we have been discussing our hypothesis that yields will rise faster than priced in and we have shown some empirical evidence of how this can evolve.
There may be situations in financial markets that can push yields down, however transitorily. However, we believe that such occurrences have lower odds of materialising and hence continue to expect a quicker rise in gilt yields in the future. The above analysis has implications for liability driven investment (LDI) and fixed income strategies. For LDI strategies, current hedging positions and even further de-risking may remain appropriate, but market conditions should be understood, particularly in the context of the pace of increasing hedging. For other fixed income strategies, we prefer seeking a diversified return and believe that active management across types, sectors, geographies and the credit spectrum should be accessed to generate additional return.
Any changes to strategies should be considered in the context of scheme specific requirements with explicit advice. To discuss these issues further please contact your Investment Consultant or Aniket Bhaduri – Aniket_bhaduri@jltgroup.com.