Intro: More so than any other financial market asset, long-term government bonds tend to closely track the economic fundamentals of a country and are much less susceptible to wild swings compared to equity markets. Supply and demand determine bond prices and therefore yields, with supply impacting demand via inflation.
Unlike stocks and currencies, which can move independently of macroeconomic trends or central bank policy, bonds tend to exhibit less wild swings, and closely track economic fundamentals and/or central bank policies. Bonds tend to return less than equities over the long term because investors are willing to accept this as a trade-off for less downside volatility during economic weakness.
Supply and Demand
The price of a bond and therefore its yield are driven ultimately by supply and demand. Demand comes from investors and speculators who want to maximise returns and minimise risk. The bulk of bonds are held by long-term investors such as pension and or insurance companies as well as central banks, but the marginal buyers (the ones that move the market in the near term) are speculators. On the supply side, there’s the government which issues bonds of varying maturities to pay for its fiscal deficits and to provide liquidity to the financial markets.
Inflation and Inflation Expectations
Inflation is the link that connects the demand for and supply of bonds. Fiscal deficits lead to increases in government bond supply which causes prices to fall and yields to rise, all else equal. At the same time, the increase in bond supply causes inflation expectations to rise (again, all else equal) thereby increasing the yield that investors require. Put another way, if investors expect high inflation, they will tend to prefer other assets that protect against inflation, and so will require a higher yield to entice them to hold bonds.
For most developed markets, breakeven inflation expectations are available, which show investors’ expectations of where inflation will average over a particular period (typically 10-years). This is derived by looking at the difference in yield between the regular bond and the equivalent maturity inflation-linked bond, with the difference being that the latter pays the coupon and an additional payout based on the prevailing inflation rate. If investors are willing to accept a yield of 5% on a regular bond yet will accept 1% on an inflation-linked bond then inflation expectations must represent the difference of 4%.
Real GDP Growth
For developed markets, the faster real GDP growth, the higher the yield that investor will require to hold a bond. Because other opportunities for high returns are likely to be available in a fast-growing economy, this will push up yields on bonds. This means that for developed markets, nominal GDP growth expectations (real GDP plus inflation) tends to determine bond yield trends. The faster nominal GDP growth, the higher the yield that investors will require to hold bonds.
Bond Yields Versus Nominal GDP
For developed markets, given that inflation and real GDP growth are the main drivers of government bond yields, nominal GDP can be compared to bond yields to give an idea of whether bonds are attractively valued. If bond yields are higher than nominal GDP, this suggests, all else equal, that bonds are attractively valued as there is potential for yields to gradually fall in line with fundamental pressures. This relationship is clearly born out in the data.
Nominal bond yields cannot remain significantly higher than nominal GDP for extended periods because an ever-increasing share of GDP would go to bondholders. Demand for bonds would increase and supply would fall until yields fell back in line with nominal GDP. Conversely. if nominal GDP growth is higher than bond yields, the reverse would tend to occur.
The Crucial Role of Central Banks
Under free market forces bond yields would tend to closely track nominal GDP growth. Usually, central bank policy is set such that interest rates (and thus bond yields) are in line with market forces, hence the strong long-term correlation between US bond yields and US nominal GDP. However, in recent years, activist monetary policy has driven bond yields significantly below nominal GDP, and even significantly below inflation expectations in some cases, with the UK being the best example of this.
The yield on a 10-year bond can be thought of as an estimate of where investors expect the country’s policy rate to average over this period plus a term premium reflecting the higher uncertainty of long term bonds relative to short term bonds. Therefore, even if nominal GDP is strong, if the Bank of England wants to keep its short-term policy rate at around zero, and investors expect this to continue, then they will be willing to accept a low yield on 10-year bonds even if nominal GDP is high. For this reason, the bias of a central bank can be a major factor determining bond performance.
QE has been a game changer for fixed income markets. By creating money out of thin air to buy bonds this puts direct downward pressure on bond yields. However, at the same time it puts upward pressure on inflation expectations, which itself will put upward pressure on bond yields. The determining factor as to which force dominates depends on which force dominates, but contrary to popular belief, QE has actually tended to put upside pressure on yields in recent years. In real terms, however, QE results in unequivocal downside pressure as shown by inflation-linked bond yields.