A rather fascinating article posted on the Bank of England’s Bank Underground website by Paul Schmelzing at Harvard University takes a very, very long look at the global bond market. In fact, given that his data set goes back to 1285, this is one of the longest long-term analyses of the blond market that I’ve seen anywhere! Additionally, the author provides us with a glimpse of what may lie ahead for the bond market by looking at past bond market “readjustments”.
Let’s open with this graphic from his posting which shows the global risk free interest rate since 1285 along with the bond bull markets that are shaded in blue:
As you can see, at 36 years, the current bond bull market was one of the longest in history with only two previous bull markets being longer; the bond market rally at the peak of Venice’s commercial domination in the mid- to late-1400s and the century following the Peace of Cateau-Cambresis between 1558 and 1664.
Here is a graphic showing the length and size (as measured using the fall in interest rates) of bull markets since 1285:
Let’s take a closer look at bond bear markets. According to the author, there are three types of bond bear markets as follows:
1.) Inflation Reversal: This type of bond bear market was experienced in the years between 1967 and 1971 and is associated with a sharp change in consumer price inflation (CPI). Between the years of 1965 and 1970, annual increases in CPI tripled from 1.6 percent to 5.9 percent; this resulted in U.S. bonds losing 36 percent of their value in real terms. Here is a graphic showing what happened to bond price returns (dark blue bars) and the yield on ten year Treasuries (light blue line):
3.) The VaR (Value at Risk) Shock: This type of bond bear market was experienced in 2003 in Japan when actions by the Bank of Japan resulted in a yield curve steepening as shown on this graphic:
Prior to March 2003, there was a significant flattening of the yields of Japanese Government Bonds (JGB). In mid-2003, there was a rapid steeping of the JGB curve, thanks in part to actions by the Federal Reserve and changes in the expected duration of the Bank of Japan’s quantitative easing program. This meant that, in order to reduce their risk profile on their holdings of domestic government bonds (i.e. the Value at Risk), Japan’s banking sector had to sell their JGB assets, which resulted in an interesting conundrum; the more bonds that the banking sector sold, the more the price dropped and the more the yields rose. This forced the banks to use interest-rate swaps as a hedging tool to reduce further losses on their bond portfolios. It is interesting to note that this occurred after the Bank of Japan announced its experimental quantitative easing policy in March 2001 in a desperate attempt to prod some life into the Japanese economy.
Let’s close this posting by quoting from the author’s final paragraph:
“On balance, then, more than to a 1994-style meltdown, fixed income assets seem about to be confronted with dynamics similar to the second half of the 1960s, coupled with complications of a 2003-style curve steepening. By historical standards, this implies sustained double-digit losses on bond holdings, subpar growth in developed markets, and balance sheet risks for banking systems with a large home bias.“
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