The 34-year bull market for U.S. bonds may be coming to an end as the Federal Reserve prepares to raise interest rates and the U.S. economic recovery continues to roll on. But that doesn’t mean a bear market is imminent, some market participants say.
The Fed won’t raise rates sharply enough, and the economy won’t grow strongly enough, to spark a bear market, they say. And the premium of U.S. yields over those in developed foreign economies will boost foreign demand for Treasuries, also helping to circumvent a bear market.
“I’m not sure we will see 1.38 percent again,” says David Ader, head of rates strategy at CRT Capital Group in Stamford, Connecticut, referring to the record low yield for the ten-year Treasury note, reached in July 2012. “We would need another recession for that. However, I’m not sure a bear market is starting. We’re in neither a bear nor a bull market. I think we’ll have sideways trading for years to come.”
As for the Fed, although central bank officials have indicated it will probably start raising rates this year, they have also made clear that rate increases will be gradual and shallow. The Fed’s federal funds rate target has stood at a record low of zero to 0.25 percent since December 2008, and Fed officials generally see the rate rising only to 1 to 2 percent by the end of next year. “I think the Fed will remain accommodative, so low rates will be with us for some time,” much lower than in prior periods of Fed tightening, says Katherine Nixon, chief investment officer at Northern Trust Wealth Management.
When it comes to the economy, demographics will limit growth, she says. Retiring baby boomers will continue to reduce the labor force participation rate. That rate matched a 37-year low of 62.6 percent in August. “That suppresses long-term GDP growth,” Nixon says. Northern Trust forecasts growth of 2.7 percent for next year.
The low workforce participation rate also puts a damper on wages, which will help limit inflation, she says. Average hourly wages climbed just 2.2 percent in the 12 months through August. And the Fed’s favored inflation gauge, the personal consumption expenditures (PCE) price index, advanced only 0.3 percent in the 12 months through July.
“The inflation expectations priced into the market put the average for the PCE index at 1.6 percent over the next 30 years,” says Shyam Rajan, head of U.S. rates strategy for Bank of America Merrill Lynch in New York. “It’s hard to see a huge bond market sell-off based on that number.”
Then there’s the foreign picture. “Global growth is slowing, and that will keep global rates much lower than historically,” says Michael Collins, co-manager of the Prudential Total Return Bond Fund in Newark, New Jersey. International Monetary Fund managing director Christine Lagarde recently said that the IMF will likely lower its global growth estimates of 3.3 percent for this year and 3.8 percent for next year when the new IMF World Economic Outlook is released in early October.
With the ten-year German government bond yield at 0.65 percent and the ten-year Japanese government bond yield at 0.31 percent, the ten-year Treasury yield of 2.15 percent looks very attractive to foreign investors. “We’re the best house in a paltry neighborhood,” Nixon says. “As the ten-year yield creeps toward 2.25 percent, you do see demand from foreign investors.” She sees the ten-year Treasury yield moving between 1.75 percent and 2.25 percent over the next 18 months.
To be sure, some are more bearish on bonds. “With better global growth and inflation percolating, we will move to a secular rise in interest rates,” says Kathleen Gaffney, lead portfolio manager for Eaton Vance Bond Fund in Boston.
On the U.S. economic front, “one of the missing pieces in the recovery is a lack of investment spending,” she argues. With the Fed keeping rates so low, companies have felt more comfortable borrowing money to buy back shares than spending on investment. “But once the Fed begins its lift-off process, there will be a strong incentive for companies to think about spending,” Gaffney says. “It’s important for the future health of the economy for them to start investing.”
Other market participants, however, are more sanguine about bonds. “The demise of the bond market has been called consistently since the peak of the financial crisis,” says CRT’s Ader. “But it has defied everyone who says, ‘This is it.’”
