Hindsight is an exact science, as English humorist Guy Bellamy noted. In hindsight, it's hard to disagree that the past four decades' economic policy has delivered a nirvana state for global bond markets. After spiking the federal funds target rate to 20% in 1980 to vanquish 1970s' inflation, the key policy rate has completed its cyclical decline to zero in the aftermath of the global financial crisis. Bond yields have followed and now sit at their lowest levels in the post-World War II era.
Conveniently for bond investors, lowering rates has been the primary policy tool in achieving economic objectives such as maximum employment and economic growth during this run. This aligned bonds' total returns with the well-being of the broader economy. Now, however, after a decade where rates have been mostly stuck at zero, the backdrop for economic policy in the decade ahead looks totally different than prior iterations. Challenges include sluggish nominal growth, a return of inflation, an aging population and overhanging debt. Hindsight will reveal any shift in this alignment, and a change will seem obvious in retrospect. It's time for asset allocators to realize that this 40-year alignment between bonds and economic policy could have reached its turning point.
For the optimist hoping to witness the prolongation of the greatest bond bull market in history, the apparent path appears to run through a continued declining trend in interest rates. This scenario implies not only an extension of the downward pressure on yields out to further maturities, but also a likely movement of the U.S. Treasury yield curve into negative territory for the first time.
At first, this seems plausible. Many developed countries have already taken their yield curves negative over the past decade, and consensus so far suggests they have not met much harm. Markets have been willing to absorb bonds priced at negative yields: over $16 trillion of outstanding debt traded at negative yields by the end of 2020, according to a Bloomberg tracker. Having watched others take this first plunge, with the leap appearing safe, asset allocators might be complacent for what follows.