No one working today will live long enough to see the bond bubble burst, according to Artemis’s Stephen Snowden, who says fixed income hasn’t just been rallying for 30 years, but since 3,000BC.
Just like many of his peers, Snowden, who is head of fixed income at Artemis, grew up in the 1980s and 1990s. However, he said that while many other fund managers believe that the interest-rate environment will eventually revert back to the “normal” conditions seen in these decades, it is worth taking a step back to consider how unusual this period of time actually was.
“Anybody of my vintage probably looks at the bond market now, looks at how low yields are, and thinks, ‘it’s totally insane, it must sell off eventually’,” he said.
“But that’s because we’ve lived through a highly unusual period of time. For hundreds and hundreds of years, interest rates have actually been quite stable.
“So, when is it going to burst? Well, no time soon, the rally has been going for 5,000 years,” he added, pointing to a graph showing the history of interest rates going back to 3,000BC.
“I suspect none of us in the room will live long enough to see this bubble bursting.”
The manager believes there are other reasons, specific to the current environment, why the bond rally is likely to continue. But to understand these, he said first it is important to remind yourself what a 10-year bond yield actually is – a prediction of the average base rate over this period, plus some compensation, in the form of a term premium, for the volatility of inflation and interest rates.
“Please keep that in mind,” he added. “Bond yields will come down as interest rates and inflation come down.
“But a bond yield will also fall if the volatility of interest rates and volatility of inflation is low. What we’ve seen for 800 years is one-way traffic in terms of the volatility of inflation.
“That means bond yields must be lower. Now as interesting as 800 years’ worth of data is, let’s look at something a bit more relevant. If you look back at the last 50 years in emerging markets, the US or the developed world, inflation has fallen materially. And not only has inflation fallen, but the volatility of inflation has fallen.
“So, the lower the volatility of inflation, the lower bond yields must be.”
One of the major drivers behind the fall in inflation and its volatility has been technology. For example, the cost of lighting a home fell dramatically with the invention of electricity, and has continued to decline as light bulbs have become more efficient.
Snowden noted this trend is also visible at a micro level, pointing to a study by The Quarterly Journal of Economics from August 2007, which showed how the roll-out of mobile phones affected the sardine market on the west coast of India in three distinct areas.
Highlighting a graph of sardine prices in the first region, he said: “You can see the price of fish was incredibly volatile before the introduction of mobile phones, but volatility fell very quickly as the penetration of mobile phones increased.
“Then when mobile phones were widely adopted, the volatility of the price of fish fell considerably. This was repeated in all three regions: as soon as mobile phones were rolled out, the volatility of the price of fish fell considerably.
“The price of fish fell by 4 per cent, but the volatility of the price of fish went from 65 per cent down to 14 per cent – absolutely stark evidence of the impact that technology has on inflation.”
Snowden admitted that the results of the study have been denounced as “a little bit fishy”, with critics pointing out the boats were likely to have been equipped with two-way radios before the rollout of mobile phone services.
However, he said the data shows that almost all of the fish were sold in the fisherman’s home port before the roll-out of mobile phone services, whereas after, about one-third of their catch ended up going to other ports.
There are more recent examples of this as well. Singapore and South Korea spend by far the most on automation per employee, and inflation is almost non-existent in these countries.
Snowden said low and stable inflation caused by technological advances, as well as an ageing population, will mean more and more bond yields will turn negative in real terms. However, he said the early signs are this will not lessen the draw of the asset class.
“It is regrettable that bond yields are low and inflation is frequently higher. But that doesn’t mean that the bond market is going to sell off,” he explained.
“Historically, there was a reasonably good correlation between the real rate of return on government bonds and the [household] savings rate. But more recently, this relationship has totally broken down and, despite the really bad real rate of return that we’re getting on the bond market, savings are surging.
“Now we can all speculate why that is. But it might be a reasonable assumption that because your assets aren’t going to make you a lot, you have to save more for retirement.
“Low yields bizarrely make you save more,” he finished.