Why US bond yields could reach five per cent

Look at the chart above of US 10 year Treasury bonds yields and you have an almost complete explanation of the fierce bear market that has particularly affected growth shares. Yields plunged with Covid in the early part of 2020 setting the scene for the last explosive leg of the bull market. Since then bond yields have risen almost 10-fold from their low point.

We can see some other things on the chart. In the early 1980s Margaret Thatcher was in power in the UK and Ronald Reagan in the US. These two leaders saw the defeat of inflation, the collapse of the Soviet Union and a victory for shareholder capitalism as the best way to create wealth and opportunities for people, rich and poor. A belief to which I still subscribe, hence my great admiration for these two leaders.

Thanks to their success and a general shift in the idealogical climate away from state owned enterprises, which always ends in tears however great an idea it seems when first mooted, there was a sustained fall in inflation and bond yields which helped drive a long running equity bull market.

As always things went too far and we ended up with the excesses of the ‘liar loan’ era in the middle 2000’s when in order to borrow money you just had to say how much you earned. Nobody checked so you could say what you liked and pretty much borrow what you liked. Happy days until Northern Rock and Lehman Brothers went bust and western capitalism was rocked to its foundations.

Enter figures like ‘helicopter Ben’ Bernanke, who promised to keep the US economy afloat even if he had to drop $100 bills from helicopters and we entered the era of quantitative easing. It seemed to work. The consumer kept spending rescuing the global economy and interest rates and bond yields kept falling. As a rough rule of thumb bond yields before Ben were around five per cent.

They fell steadily to around two per cent and stuck around that level until Covid triggered that final plunge to a low point of 0.332pc. In this period countries like Germany and Japan experienced negative yields where the government paid you to hold their bonds, an Alice in Wonderland world indeed.

Governments were able to get away with even more dramatic quantitative easing/ money printing in this period because everybody was stuck at home unable to spend their money. E-commerce boomed and savings piled up in households some of which was used to push share prices higher to what we can now see were wildly unsustainable levels.

Since those happy days bond yields have been rising as fast as they fell pulling the rug out from under equity prices. Inflation has soared to 40 year highs fuelled by all that money sitting on the sidelines and widespread shortages of everything, many of which I still find a little mysterious. Even people are in short supply in this brave new world so it is hard to find anyone to do anything and oil, gas and wheat are becoming as valuable as gold thanks to the stand off between Russia and the West over Ukraine.

Dredging my memory banks I can remember a day when economists thought that the real inflation adjusted return on long-dated bond should be around three per cent. You could then work out the nominal yield by adding inflation. These economists would have imagined that if US 10 year Treasury bonds were yielding around three per cent that inflation must be around zero, not around eight per cent. It’s a funny old world, as they say.

This leads me to think that it would not be astonishing if bond yields rose higher from the present 3.3pc to more like five per cent which is where it all started before the 2008 financial crisis and helicopter Ben. The chart is compatible with bond yields rising further and five per cent yields would be a test for shares.

This is just a guess. I don’t have a crystal ball but it creates a framework for thinking about these things.

Remember that none of this affects company fundamentals. Exciting companies don’t stop being exciting companies because of a tougher macroeconomic environment but as we have seen this can affect their shares, by a lot if they are high momentum, high growth businesses whose shares have risen very high.