Long view: History supports bond yield fears

By John Authers

Published: February 11 2011 23:23 | Last updated: February 11 2011 23:23

When worried about the short-term future, look to the long-term past for guidance. This week, the annual
publication of two huge research projects into the performance of long-run securities suggest we should fear a
rise in bond yields and a resurgence in inflation.

The Credit Suisse Global Investment Returns Yearbook, produced by academics at the London Business School
for the past 11 years, and the Barclays Equity-Gilts Study, overseen by the various incarnations of Barclays
Bank’s securities business since 1956, agreed that, in the long term, equities will outperform bonds and cash.
Barring world wars, 20 years is almost always long enough for equities to outperform cash. Both also agree that,
in the last decade, bonds beat equities for the first time since the 1930s.

Equities naturally tend to dominate perceptions. But both surveys tend to focus attention on bonds. During the
20th century, they were a vastly inferior investment to equities. But US Treasury bond yields have been locked in
a protracted downward trend (or put differently, bond prices have been going up) since the mid-1980s, when
the Federal Reserve convinced markets it was prepared to cause real economic pain in its effort to contain
inflation. Long-term bond yields – which need to be high if investors think they need to protect against inflation
in the future – steadily fell.

Most bond traders now working cannot remember a time when bond yields were not gradually falling. But the
Credit Suisse work suggests they have in fact lived through a protracted historical anomaly. Since 1982, the
average annual return (combining price appreciation with interest payments) on long-dated bonds compared to
short-dated bonds, has been 5.2 per cent. Since 1900, however, that figure has been only 0.8 per cent.

To quote the authors: “Hoping bond returns will match the period since 1982 is a fantasy.”

This is also a concern of Barclays, which for years has warned that inflation will return. Its study says the period
from 1982 until the credit crisis started in 2007, often called the Great Moderation, was “the exception”.

One critical reason for this comes from the emerging world. During the Great Moderation, its supply of cheap
labour exported lower inflation to the rest of the world. Now, that has turned. As Barclays documents in chilling
detail, emerging markets’ demand for resources is now exporting inflation, notably in industrial metals and in
food. The natural response of central banks would be to raise rates – which leads to higher bond yields and
lower bond prices. History, therefore, suggests that the risks are firmly tilted towards rising bond yields.

What would higher bond yields mean for stocks? A popular model – generally nicknamed the “Fed Model” –
holds that bond yields drive equity valuations. Higher yields from bonds will attract investors unless higher
earnings yields (another way of saying lower price/earnings multiples) are forthcoming on stocks. There have
been long periods when this model has worked well.

There have also been periods, such as the last decade in the US, when it was the complete opposite of the truth:
bond yields fell over the last decade, but so did earnings multiples on stocks.

Long-term research by Jacques Hirsch of Société Générale suggests that the relationship between bonds and
stocks depends on the level of bond yields. When yields are low (as they are now), then rising yields show
optimism about growth and do not crimp the style of companies raising money – so rising bond yields can go
hand in hand with rising equity prices. This is what is happening at present.

But once bond yields move above 5.2 per cent, the relationship flips. Higher yields imply that central banks have
real concerns about inflation, and make it materially more expensive for companies to do business. And indeed,
it was a scare in the bond market, with Treasury yields rising above 5.2 per cent, that triggered the credit crisis in
the summer of 2007. If yields get that high again, the ongoing downward trend in yields will have been broken.

How does this long-term evidence bear on the crude short-term? Ten-year Treasury yields are at 3.65 per cent
and rising, but there is a way to go before the 5.2 per cent watershed. For now, their rise reflects optimism
about the growth prospects of the developed world (swamping the fresh scepticism about the prospects of the
emerging world). Central banks are still not tightening.

There are ample historical reasons to fear for the long-term future of stocks, as well as bonds. But history also
suggests that the recent trend of selling bonds and buying stocks could easily continue for months before its
next interruption.

•Equity Gilts Study, published by Barclays Capital. £100

•Credit Suisse Global Investment Returns Sourcebook and Yearbook 2011, by Elroy £250