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The fact that this chart of bond market returns over the past 40 years is mostly green seems to make it the ideal marketing material for bond investors: in just four out of the past 40 years did bonds yield negative returns! It reminds us of the quote by the philosopher Ludwig Wittgenstein, who once wrote: “Tell me how you look, then I will tell you what you are looking for.”
Alas, there is a powerful framing effect at work here: we are looking at one of the largest bull markets in history. If the analysis is expanded to include data going back to 1900, we see that bonds yielded negative returns in 18% of the cases. 1 Perhaps the bond bulls should be grateful to Paul Volcker. When Volcker took office as Fed chair in 1979, he curbed inflation with his infamous cold turkey approach by aggressively raising policy rates to bring inflation back under control.
Although this was an economically costly approach, it proved effective to topple inflation. Content with receding inflation, but cognizant of the economic costs of Volcker’s approach, central banks then moved on to a more a rules-based monetary policy framework in the 1980s and 1990s that targeted inflation and was considered credible and transparent.
Although many other factors were at play, this bond-friendly evolution in monetary policy has certainly contributed to the great bond bull market of the past decades. In hindsight, central banks’ measures targeting inflation may have been even more beneficial for bonds than the ‘Greenspan put’ has been for stocks. After the Great Financial Crisis, the bond market entered a new phase with the market itself becoming instrumental in achieving central bank inflation targets as QE was implemented.
Looking ahead, it is quite likely that bond bulls will be challenged if the global cyclical upswing continues in 2018. The German bond market has not shown such a disconnect with fundamental pricing factors like real GDP growth and inflation for over 50 years, foreboding negative returns in the medium term. The culprit: the bond-buying policies pursued by central banks in recent years, which have artificially suppressed yields below fair value.
Central banks are now looking to change their policies in 2018. Sustained macroeconomic momentum and reflation are giving central banks the confidence they need to transition from quantitative easing to quantitative tightening and shrink their balance sheets. With inflation close to the target, but still just below it, a cold turkey approach is out of the question.
Instead, central banks will prefer to take the punchbowl away only gradually, and bond markets will be given the time to adapt. However, amid record low levels of volatility, a market could easily fall prey to a sell-off if forward guidance about this transition somehow fails.
That bond markets do not like to be surprised by hawkish central bankers is all the more evident from the graph: the few instances of negative returns in previous decades were in years in which central banks upset markets with unanticipated announcements regarding their policies. All in all, there is certainly risk involved in what is commonly known as the ‘risk-free asset class’.
This article forms part of the Robeco 2018 outlook entitled Playing in Extra Time.