DB CoTD Make Bonds Boring Again

DB CoTD: Make Bonds Boring Again.... Jim Reid

I've published my new Chartbook this morning on the Deutsche Bank Research Institute site here, where it is open to all. Titled " The Home Straight ", it examines the key market themes as we enter the final stretch of the year.

We lead with the recent rise in bond yields and place the move in a longer-term context. While the forces pushing yields higher are unlikely to fade anytime soon, we argue that the latest increase is less a new regime shift or an immediate fiscal story, and more a continuation of the long normalisation from the extraordinary conditions of the 2010s. We also make the case for a modest Fed hiking cycle and explain why the ECB is likely to deliver two further rate hikes this year. Elsewhere, we assess developments ahead of the US mid-term elections, review one of the strongest global earnings seasons on record in Q2, and continue our focus on the implications of AI for markets and the economy.

The lead theme is bonds. For more detail, see my FT op-ed here. A central argument in both the article and the opening section of the Chartbook is that bonds are becoming normal again in yield terms rather than being extreme. Today's CoTD highlights one way of viewing that adjustment.

Since the early 1960s, 10-year Treasury yields have broadly tracked a rolling 10-year average of nominal GDP growth, with two notable exceptions: the late 1970s and early 1980s, when yields moved well above nominal growth, and the 2010s, when they sat meaningfully below it. Over the full period, nominal GDP has exceeded 10-year yields by an average of around 70bps. Given a current 10-year average nominal GDP growth rate of roughly 5.5%, that points to a 'fair' yield of around 4.8%, exactly where we are today.

However, that’s a 10-year moving average. Current nominal GDP growth is running at 6.6% YoY, the strongest pace since 2005 outside of the post-Covid rebound. So should yields be higher? In Q2, nominal growth was boosted by the energy shock so that seems a little extreme, unless it becomes permanent, but maybe with the AI boom, and inflation which has been stubbornly above target for over 5 years, perhaps nominal GDP should currently be moving above its 10-year moving average, thus dragging yields higher.

That said, it’s certainly not all bad news. As discussed in last Wednesday's CoTD and reiterated in the pack, 10-year Treasuries would still generate a positive 12-month total return provided yields remain below roughly 5.5% over the next year. Over a two-year horizon, that breakeven rises to around 6.4%.

So while upward pressure on yields may persist over the next 12 months, investors have a reasonable degree of protection on offer. Returns may not be spectacular, particularly in real terms, but after a long absence in the 2010s and early 2020s, bonds can at least be called bonds again.

See my pack here for more on this and much more.