Investors have benefited over the past three decades from an unprecedented bull market in bonds since long-term government bond yields peaked at 14.8% in September 1981. Aggressive monetary tightening by Paul Volcker, Chairman of the Federal Reserve at that time, drove inflation from double-digit levels in 1981 to less than 3% in 1983. Continued vigilance by the Federal Reserve combined with deregulation, globalization and, until recent years, lower oil prices set a trend of disinflation and lower interest rates firmly in place.
As bond investors priced ever-lower inflation expectations into their return requirements, yields declined and created capital gains for bondholders. Since September 1981, the annualized returns from long-term government bonds of 10.8% rivalled the 11.2% return of the S&P 500 stocks. However, barring a serious double-dip recession, the trend of declining yields and robust gains is a thing of the past.
Many investors are not aware that the great bond bull market of the last three decades had its genesis in a devastating bond bear market that ran over 35 years from 1946 when WWII price controls were lifted until September 1981. The gradual entrenchment of higher inflation expectations, after the 1973 oil crisis in particular, propelled yields upwards. As evidenced in the following chart, long-term government bonds yields (in red) rose from 1.98% in March 1946 to 14.8% in September 1981.
During this period, investors in long-term government bonds earned a paltry 1.6% as capital losses induced by rising rates overwhelmed the income return. Real returns (i.e. net of inflation) were negative at -2.9% annually. In contrast, stocks earned a 10.2% nominal annual return and 5.2% after inflation.
Long-term bond yields have always been subject to lengthy secular cycles. Prolonged periods of falling yields and rewarding bond returns have been regularly followed by drawn-out periods of rising yields and subpar returns. Appendix I sets out this secular pattern of yield changes over the past two centuries while Appendix II contains a chart of U.S. federal debt. With the exception of WW II when the Federal Reserve worked with the Treasury Department to maintain low yields, cyclical peaks in bond yields have often been associated with government funding stresses in times of war (e.g. War 1812-14, Civil War and WWI).
The secular cycle in bonds is evidenced in the following chart which illustrates long-term U.S. bond yields since 1900. Of note is the fact that yields rose from 1900 to 1920, a period of rising commodity prices, stimulative monetary policy in the form of growing gold supply, increasing regulation and banking reform. Government funding requirements for WWI were the final cause of higher rates. The parallels to our current situation are obvious.
Although the U.S. is under tremendous deflationary pressure from excessive leverage and production capacity, so long as some shock does not tip the economy into a double-dip recession, a new secular cycle in long-term rates is in the process of forming. The Federal Reserve, with an eye to the policy errors of the 1930's and Japan, is likely to err on the side of a loose monetary policy for years. Skyrocketing federal debt will demand a higher risk premium and the government will be tempted to let inflation re-ignite so as to reduce its debt burden in real dollars. Higher taxes and regulatory costs will be passed along to consumers through higher prices.
The good times for bonds couldn't last forever. Although some longer-term bond exposure is needed today as a hedge against a deflationary scenario, investors should recognize that in the next year or so the bond roller coaster is about to get underway.
Appendix I
Long-Term U.S. Bond Yield Cycles
Source: A History of Interest Rates, Third Edition
Appendix II
U.S. Federal Debt as a Percent of GDP
Source: http://www.usgovernmentspending.com/downchart_gs.php?year=1792_2010&view=1&expand=&units=p&fy=fy11&chart=H0-fed&bar=0&stack=1&size=l&title=US%20Federal%20Debt%20As%20Percent%20Of%20GDP&state=US&color=c&local=s
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