INVESTMENT

Why the increase in bond yields should only be modest


Commentary by Alexis Gray, MSc, Vanguard Asia-Pacific Senior Economist

The Kovid-1 pandemic epidemic has made it abundantly clear that the central bank has the tools to deal with the dramatic decline in global economic activity and is willing to use them. The economy and financial markets that were able to find their position very quickly after several horrific months in 2020, due to monetary policy it was not in a small part that made the bond markets liquid and orrow the conditions much easier.

Now, as newly vaccinated individuals provide their paint-up demand for products and services that may initially struggle to hold, naturally the question arises about revived inflation and interest rates and what central banks will do.

Vanguard’s global chief economist, Joe Davis, recently wrote about how rising inflation is unlikely to spiral out of control and could support a more promising environment for long-term portfolio returns. Similarly, in an unintentional upcoming study of loose monetary policy, we see that the central bank’s policy rates and interest rates are likely to rise more widely, but only modestly in the next few years.

Prepare for a policy rate lift-off … but not immediately

Date of withdrawal 2025 2030
US Federal Reserve Question 3 2023 1.25% 2.50%
Bank of England Question 1 2023 1.25% 2.50%
European Central Bank Question 4 2023 0.60% 1.50%
Comments: The withdrawal date is the estimated date of each central bank’s short-term policy interest rate increase from the current low to the target. The rates for 2025 and 2030 are vanguard projections of the policy rates of each central bank.
Source: Vanguard forecasts until May 13, 2021.

Our view that a lift from the current low policy rate may in some cases reflect only a gradual recovery from the significant impact of the epidemic on the labor market, among other things, just two years from now. (My colleagues Andrew Patterson and Adam Schilling recently wrote about how inflation and the prospect of a labor market recovery will allow the US Federal Reserve to be patient when considering when to raise the benchmark federal funds rate target.)

In addition to the policy rate hike, Vanguard expects central banks, in our base-case “reflection” situation, to slow down and eventually stop buying government bonds, allowing their balance sheet size to return as a percentage of GDP – epidemic levels. This catastrophe in the bond-buying program will probably put some ward upward pressure on yields.

We expect the balance sheets to be larger than in history, but for structural reasons, such as the central banks managing monetary policy since the 2008 global financial crisis and the tightening of capital and liquidity requirements in banks. In light of this change, we do not expect that the shrinking central bank balance sheets will put significant ward upward pressure on yields. In fact, we expect higher policy rates and smaller central bank balance sheets will only lead to a modest yield. And we expect that for the rest of the 2020s, bond yields will be lower than before the global financial crisis.

Three scenes for 10 year bond production

Source: Bonds obtained from Bloomberg Historical government bond yield data. Vanguard Forecast, May 13, 2021, made from Vanguard’s proprietary vector error correction model

We expect yields to rise higher in the US than in the UK or the eurozone because the Fed has more expected declines on the balance sheet than the Bank of England or the European Central Bank and higher or higher than others due to Fed policy rate increases.

Our base-case forecast for the production of 10-year government bonds towards the end of ten years reflects the monetary policy that we hope has reached a balance-policy that is neither consistent nor limited. From there, we assume that central banks will use their instruments to make orrow terms easier or more appropriate.

The transition from a low-yield to a medium-high-yield environment can bring some initial pain through capital loss within a portfolio. But this loss can be offset by a larger income flow as new bonds bought at higher yields enter the portfolio. At any rate, we expect bond yields to increase in the next few years will be modest.

I would like to thank vanguard economists Sean Raithatha and Roxanne Spitznagel for their invaluable contributions to this commentary.

Comments:

All investments are at risk, including the potential loss of money you invest.

Investing in bonds is subject to interest rates, credit and inflation risk.

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