Global Bond Yields have limited scope to fall further
At 1.8%, the real yields of global bonds - namely the average yield of 10 year US, Japan and Euro bonds based on core inflation - are close to the lowest level reached in the past 15 years (of 1.5%). Japan’s experience suggests that real yields of between 1% and 2% might be normal in a low inflation/deflationary environment; however, we expect US inflation to rise towards 2.5% this year.
Thus, at their current levels, global bond yields, particularly treasuries, look fairly expensive relative to their history and compared to the valuation floor established by Japanese bonds. This suggests inflation adjusted US treasury yields may struggle to rally further below 4%.
Even if the US Federal Reserve pauses its rate rises at 3.5% this year, 4% yields will imply a very flat yield curve. We currently expect the US Fed to return interest rates to more normal levels without causing growth to fall sharply, which means a positive yield curve is a more likely outcome.
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In Europe, real yields at 1.7% are even closer to historic lows but, given our expectation that core consumer inflation and interest rates are likely to be flat this year, these levels are more justifiable. We believe US treasury yields could reach the high end of the range established over the past two years of 3.75% - 4.75% towards the end of the year, particularly if the status quo of robust US demand and the risk of higher inflation are unchanged.
By John Stopford, head of Fixed Income at Investec Asset Management
