There are several significant reasons that should lead to a 2.70 percent + year-end yield and a mild bear market total return of 0-1 percent for most bond portfolios. It’s hard to prioritize one versus the other but let’s start with the nominal economy. Long stuck in a 4 percent plus or minus range that led to mild bond price changes despite a series of Fed hikes, the nominal economy now looks capable of 5 percent for at least a few quarters. Tax cuts and increasing budget deficits are providing a temporary fiscal push that likely will increase future inflation to the 2 percent core target long desired by the Fed. 3 percent real growth, although perhaps illusionary in your author’s opinion, gives the economy that 5 percent nominal number that overvalues 10-year Treasuries at 2.5 percent. Historically, or better yet, in this new era of financial repression beginning with the onset of The Great Recession in 2009, the spread between 10-year Treasuries and nominal GDP has averaged 140 basis points. When using that average, a 5 percent nominal GDP mindset targets a 3.60 percent yield on the 10 year over the course of 2018. I’m not that negative but you get this fundamental point.
Secondly, the Fed and importantly other central banks are cutting back on quantitative easing. Later this year, perhaps in September, net central bank purchases of sovereign and corporate notes and bonds may stop, or at least falter far below the $1-2 trillion pace of recent years. The market’s central bank buyers of last resort have perhaps accomplished “whatever it takes,” and are set to allow artificially low yields, and artificially high bond prices to become a little less artificial. This is not to say that there will be any more than two Fed hikes this year or that the ECB, the BOE and certainly the BOJ will raise short rates anytime soon. They won’t. But the diminution of QE check writing and a 5 percent nominal GDP should be enough to produce higher 10-year Treasury yields, near 0 percent total returns, and the legitimate characterization of the beginning of a mild bear market.
Oprah shouted, “Their time has come.” The bear bond market’s time has come as well. Many would say, including yours truly—“It’s about time.”
Bill Gross is the portfolio manager of the Janus Henderson Global Unconstrained Bond and Total Return strategies and a member of the global macro fixed income leadership team.