An imperfect signal - Mawer

Bondholders have been on quite the ride in the last few months. The year began with yields moving lower in many regions—notably Europe—to the surprise of some investors who just last year thought that rates could only go higher. Yields turned negative in a fifth of all global government bonds causing many to fret that this was a signal of pending deflation. But in recent months bonds have made a remarkable about-face. A global selloff in bonds has seen yields move higher across many developed and developing countries. In Germany, the yield on 10-year government bonds even rose towards 1% this week, a level not seen since September 2014 and a huge move from the 0.08% they hit in April.

It’s been an exciting time for this supposedly “boring” asset class. And it has many investors asking, what, if anything, should they make of this? Are we now free of the deflation threat? Is inflation coming?

Answering these questions requires some understanding of yields and what they may, or may not, be telling us.

An Imperfect Signal?

Imagine that you are driving and arrive at a one-lane tunnel that takes you through a mountain. Since traffic moves in both directions on this road, someone has engineered an old light to blink when another car is already inside; if the light is on, you know another car is coming and you simply wait for them to pass through. The problem is that the light is faulty and only blinks when a car is inside about 75% of the time. So what do you do? If the light is off, do you proceed and hope you don’t meet another car coming from the opposite direction? Do you shun the broken signal altogether and turn around?

One of the most important attributes for any reliable signal is consistency. It doesn’t do anyone much good if the tunnel light only works 75% of the time. If we can’t depend that the signal is consistent, it starts to become noise.

This is one of the core challenges investors face when interpreting bond yields. In the world of finance and economic theory, bond yields can tell you an awful lot about how the world is going. Since bond investors should rationally demand protection against default and inflation, bond yields should theoretically be a useful tool in gauging the market’s view on inflation and the creditworthiness of the borrower. Often, this is exactly what bond yields do. But not always.

As an example, the yield on a 10-year German bond started the year at approximately 0.50%. It then slid to a low of 0.08% in April, climbing towards 1% earlier this week, and now roughly sits at 0.80%. Finance theory would tell us that investors were shifting their views on how the world will unfold—the lower the yields, the lower the expected growth and inflation; the higher the yield, the higher the expected growth and inflation (which is why so many people were discussing deflation when yields were very low).* But should investors assume that this is what the bond yields implied? Not necessarily. The signal here may be broken. Low German bond yields were likely driven as much (or more) by the ECB’s massive bond buying program.

To put the size of the program into perspective, from July to December 2015, the net supply of European sovereign bonds is expected to be approximately negative €200 billion after ECB purchases. This number is equal to approximately 40% of the total Government of Canada bonds outstanding! This means that the ECB’s massive buying has left essentially no supply of bonds for the rest of market participants.

As much as asset prices always tell you something about what markets are thinking, it’s hard to know exactly what. World bond markets are driven by a huge confluence of actors, including banks, pension plans, asset managers, retail investors and insurance companies. These actors almost always have some view on how the world will unfold and will incorporate their opinions into the price they are willing to pay for a bond. And economics is not the only factor for their purchase decisions. For example, most banks must hold sovereign bonds for regulatory purposes. Insurance and pension-driven investors are typically motivated to invest at any price (even if it is “uneconomic”) to match a liability. And many other investors are looking to make a quick buck by front-running central banks rather than evaluating bonds on fundamental considerations like growth, inflation or probability of default.

Moreover, the “broken signal” issue has recently been compounded by two trends. The first is central banks. Central banks have never in history been so collectively aggressive with their interventions in markets. Parsing signal from noise in this environment is enormously difficult. The second is what appears to be a trend of diminishing liquidity in global bond markets. A number of players have come out in recent months to warn about the falling liquidity in Treasury bonds—some argue up to 70% less—partly related to the de-risking of balance balanced sheets and the associated drop in liquidity that has followed. Less liquid markets are prone to bigger spikes in prices because each trade—even a relatively small one—has more impact on the market. Investors have now even more reason to be cautious interpreting bond yields.

So what should investors make of recent moves? At first glance, it would seem that the fear of a recession and deflation has lessened in recent months and expectations for a modest economic recovery and inflation might be returning. These would be good signs for the global economy and would bring comfort to policymakers, most of whom fear deflation more than inflation. But it is impossible to know for certain. There is also some chance that the recent swing in yields was more of an aberration because of central bank buying and investor positioning in a liquidity strained market.

Ultimately, we must be cautious about how we interpret bond yields and how much conviction we give to the stories we form about them. Bond yields are an important source of information, but they are imperfect.

*Yields also incorporate information on default probability. Arguably, the move in German yields could have been due to investors adjusting their views on Germany’s creditworthiness.