Bond bear awakening

How much further will bond yields rise? Ping An's head of research, Chi Lo, investigates US and China scenarios.
This global economic expansion has gone on stronger and longer than expected. Global inflation has fallen so low that it may not be compatible with prolonged economic expansion.

Global real bond yields are rising for good reasons (economic growth) but not for bad (inflation). Hence, their impact on stocks should be limited.

Volatility in bond prices is increasing, as sentiment swings between inflation and growth scares. This should create investment and trading opportunities in bonds.

Bond markets:

Chinese yields are also poised to rise due to rising inflation and increasing bond supply.
Mean reversion suggests that US 10-year Treasury yield could rise to 6% in the coming months.

Equity markets:
The rising yields will have a bigger impact on the developed equity markets, due to their large amount of debt build-up. Asian stock markets will out-perform in the coming year.

Rising real yields are bad for precious metals, but good for energy and industrial metals which benefit from economic growth.

Forces boosting bond demandà
Excess savings in Asia and other commodity-producing economies have played a large part in compressing real bond yields in recent years. Their large current account surpluses and rapid accumulation of foreign reserves have been recycled back to the developed world via massive buying of bonds, especially US Treasuries.

The force of this bond demand is so big that it has pushed down nominal yields at a rate faster than the fall in inflation. As a result, real bond yields have fallen to very low levels (chart below).

àare fading

But these low real yields are unsustainable in the face of continued global economic growth. Globalisation, financial integration and corporate restructuring have kept world growth stronger and longer than expected. Meanwhile, global inflation has fallen for too long and too low that it is likely to rise (chart below), though not in a big way due to excess capacity in many parts of the world and globalisation.

The US economy seems to have passed its weakest point. EuropeÆs growth remains solid, and Japan has entered a secular economic recovery. Domestic demand in Asia has been strengthening, with consumption and private investment growing steadily. This prolonged economic expansion is absorbing some of the savings that has been underpinning the demand for global bonds in recent years.

Asian central banksÆ bond demand is weakening, as they are trying to diversify away from conservative investments, like G7 bonds, to riskier assets so as to raise investment returns. Their bulging foreign reserves are also creating internal economic imbalances, making them more willing to tolerate currency appreciation. Even China is loosening its grip on the renminbi. Hence, less foreign exchange intervention means less foreign reserves build-up and fewer net purchases of global bonds.

Global bond yields on the rise

All these are combining to drive up bond yields. Indeed, the US long bond yield has been creeping up since it hit a bottom at 3.3% in mid-2003. Unlike the four major US bond bear markets since 1980, when yields rose by between 200 to 500 bps within 16 months, the yield ascent this time has been more subdued and long drawn out (rising by 140 bps in 44 months), thanks to excess global savings and the absence of inflation.

However, rising US equity prices are predicting better growth ahead with declining risks of the US housing market correction and sub-prime loan crisis. This suggests that the ascent of bond yields might speed up.

The amount of excess savings has dropped and the opportunity cost of holding that savings has risen sharply due to the stock market rally. China is a good example. Its surging stock prices have raised the opportunity cost of holding savings in other forms, and thus forced up long bond yields (chart below).

How high will bond yields go?

Prolonged economic expansion will soon bring real borrowing cost up to levels compatible with underlying growth. However, Inflation will not return in a big way, due to excess capacity in many parts of the world and globalisation.

Hence, bond yields will rise, but not surge to very high levels. Mean reversion suggests that US real long (10-year) yield would move towards 3.3% and nominal yield towards 6.3% gradually (see first chart above). This scenario will be compatible with a 2.5-3.0% real GDP growth rate and a 3.0-3.5% inflation rate, which are within the US FedÆs comfort zones.

What about Chinese yields?

Chinese long yields are also rising in the medium-term, but not because of the rising international trend. The lack of capital account convertibility has made Chinese bonds move on its own beat. Rising inflation (again not in a big way but from prolonged low levels) and rising bond supply (due to capital market liberalisation) will push up Chinese yields in the coming year.

The yield curve is expected to steepen, as the upside of the short-end is capped by the PBoCÆs timid monetary policy. Core inflation has remained tame at around 1% a year, and the cyclical headline inflation momentum will fade, just like in 2004/05. There will be no sharp monetary tightening, and hence the rise in short-term rates will be limited.

Nevertheless, interest rates have been kept for too low and too long. Headline CPI is going to rise further to 3.5% YoY this year and 4% in 2008, as food price increases and energy price liberalisation will feed through. The PBoC will hike rates to contain the inflation risk. Expect two more rate hikes, averaging 30 bps each, and three more bank reserve requirement ratio hikes, 50 bps each, for the rest of the year. Increasing bond supply, due to capital market liberalisation, will put upward pressure on long-term yields in the medium-term.

Impact on stock markets
Since interest rates and bond yields are rising for good reasons (economic growth) but not bad (inflation), their adverse impact on stock prices will likely be limited and short-term. Nevertheless, the impact is likely to be bigger on the developed markets than on the Asian markets, due to the huge debt build-up behind the developed marketsÆ stock rallies in recent years.

Easy credit has underpinned rising stock prices, esp. in the US, as private equity funds have borrowed heavily at low cost to buy companies at rising prices and hoped to sell them later at a profit. These debt-financed acquisitions have acted like rocket fuel for the US stock market as investors pile in, making bets on potential takeover plays.

The downside risk for the developed markets in the short-term thus lies in the potential damage of this debt-financed equity demand. Rising yield will make debt more costly, raise the risk premium and make the stock market hostile. Over $460 bn of debt related to buyouts done in the last 5 years is presently held by investors around world, according to Standard & Poors. If rising yields cause a credit squeeze, they could create a knock on effect on the world markets.

However, Asian stock markets should have a bigger cushion against this potential shock, due to their stronger fundamentals, including current account surplus, ample savings and absence of debt.

In terms of stock sectors, rising real yields are bad for precious metals, including gold. This is because their intrinsic value is negatively correlated with rising interest rates, which raise the opportunity cost of holding precious metals. Energy and industrial metals should benefit under the current rising yield environment, as they will benefit from economic growth.

Chi Lo, Director, Investment Research, Ping An of China Asset Management (Hong Kong) Co. Ltd.
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