This is not a history lesson. The point for investors is that the 35 year rally in US bonds is showing clear signs of ending.
Investors’ time horizons vary enormously. Those spending the kids’ inheritance have a different outlook to those saving for a retirement that is thirty years away. Yet we all tend towards a similar timeframe when assessing market conditions, of around one year. However, there are times when it’s important to understand market moves from a longer term perspective.
Come in US ten year bonds.
For the last thirty-five years US bonds were in a bull market. In 1981 the ten year bond yield hit a high at 15.84%. Although it wasn’t in a straight line, yields dropped over the intervening years to hit a low at 1.36% in July this year. This is one of the most extraordinarily sustained trends seen in any traded market.
The main drivers worked hand in hand to lower interest rates over the decades. After the excesses of the 70’s, central authorities around the globe were determined to “fix” inflation. The damage to economies and personal wealth from rampant inflation brought a strong focus. Policy makers adjusted fiscal and monetary structures to drive inflationary pressures lower. A local example is the wages accord struck between the Hawke Labor government, businesses and unions that tied wage increases to productivity gains.
Just as this initial assault on inflationary forces started to fade, the digital revolution kicked in. The rapid growth and spread of new technologies brought enormous, one-off productivity gains to most industries. This increase in productivity didn’t flow only to wages. Profits increased and deflationary price pressure further dampened inflation and expectations, leading to even lower long term interest rates.
Of course, the final kicker to lower yields was the quantitative easing policies enacted by central banks around the globe. This unprecedented accommodation and the historic levels of liquidity pushed bond markets to extremes, with many European issues trading at negative interest rates.
This is not a history lesson. The point for investors is that the 35 year rally is showing clear signs of ending. The Us Federal Reserve lifted rates from their lows last December, and is likely to lift rates again this December. This hike, and Republican control of the US congress and the White House, are two important reasons for a sea change in interest rates. And the price action is confirming the shift:This weekly chart shows the last decade of trading in the price of ten year bonds. As interest rates fall, bond prices go up. The most recent up trend that began in early 2014 is clearly broken. While the US Fed is adamant that the normalisation of US interest rates will be gradual and gentle, the direction is now down for bond prices, and up with interest rates.
What does this mean for investors?
Rising interest rates hurt asset prices generally, and share valuations in particular. However, this should not bring fear to investors’ hearts because the reason interest rates are rising is that the underlying economy is improving. Naturally, these conflicting currents can produce market turbulence, but they are not the outright negative espoused by uber-bears.
However, it is time to start re-balancing portfolios away from defensive earnings (property trusts, consumer staple, utilities, infrastructure, healthcare) and towards growth (energy, materials, industrials). Banks sit in the middle of these groups, and whether investors should buy or sell financial stocks depends on the current composition of their portfolios.
There are further considerations. Active investors are best placed to earn superior returns under prevailing market conditions. While the tectonic shift in interest rate markets is important, picking the right stocks remains critical. Secondly, staying engaged and responding to price changes will continue to drive returns. In simple terms, this may involve locking in good gains in one stock to buy another at a better value point. More sophisticated investors may use CFDs and options to provide an “overlay” exposure.
Whatever the choice, staying active is the key.