If you thought you had already read the gloomiest possible prognosis for bonds, wait until you read this one.

Paul Schmelzing, a PhD candidate at Harvard University and a visiting scholar at the Bank of England, said if the latest bond market bubble bursts, it will be worse than in 1994 when global government bonds suffered the biggest annual loss on record.

“Looking back over eight centuries of data, I find that the 2016 bull market was indeed one of the largest ever recorded,” wrote Schmelzing in an article posted on Bank Underground, which is a blog run by Bank of England staff. “History suggests this reversal will be driven by inflation fundamentals, and leave investors worse off than the 1994 ‘bond massacre’”.

Schmelzing, whose research focuses on the history of international financial systems, divided modern-day bond bear markets into three major types: inflation reversal of 1967-1971, the sharp reversal of 1994, and the value at risk shock in Japan in 2003.

The Bank of America Merrill Lynch Global Government Index of bonds fell 3.1 percent in its worst-ever annual loss in 1994 as then-Fed Chairman Alan Greenspan surprised investors by almost doubling the benchmark rate. Treasury 10-year yields surged from 5.6 percent in January to 8 percent in November.

The current bond market is facing the “perfect storm” of potential steepening of the bond yield curve, monetary policy tightening, and a multi-year period of sustained losses due to a “structural” return of inflation resembling that of 1967, he said. Last quarter was the worst for government bonds since 1987, according to data compiled by Bloomberg.

Global inflation expectations, as measured by the yield difference between nominal and index-linked bonds, have risen to the highest since May 2015 after falling to a record low in February last year.

“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,” Schmelzing said.

David Fuller's view

I maintain that US 10-year Treasuries will not break their July low of 1.318% during my lifetime.  In fact, it may not be broken in this century.  Why?  Because this is one of the biggest bubbles of all time.  It developed over 35 years and took US yields to their lowest levels since The Great Depression (1929-39). 

However, this is certainly not a consensus view.  Until very recently, there was a clear consensus that we were living in ‘a new normal’ of disinflation and deflation.  We were told that GDP growth in developed countries would remain historically low for many more years.  In fact, some bond market experts say that US 10-year Treasury yields will break their July 2016 lows within the next three years.  It is often hard to accept that one’s favourite trend is ending.

Consequently, for perspective we should look at some long-term charts.

This long-term chart of US 10-year Treasury Yields shows the record bull market, in terms of falling yields, following Paul Volcker’s squeeze to end inflation, which had driven yields to nearly 16% in 1981.  It does not yet provide convincing evidence that the bull market is over, but that is never apparent to all until well after the event.  However, this semi-log chart over the same period better illustrates the climactic volatility leading to and following the two troughs in 2012 and 2016. 

For additional perspective, here is the Merrill Lynch Treasury 10-Year Total Return Index on a semi-log scale and also an arithmetic scale.  The latter shows this amazing bull market becoming somewhat choppy in recent years. 

You can see the last four biggest reactions more clearly on this chart showing the total return over the last 10 years.  The most recent reaction is slightly larger although the percentages are almost identical.  Any additional weakness would provide evidence that this bubble is now leaking beyond repair.  This 1-year short-term chart of US 10-year Treasury Yields shows that the steep rise commencing in November has temporarily lost upside momentum.

In addition to this preliminary technical evidence, we see improving GDP growth fundamentals, led by the USA.  Even the Eurozone now shows some slight improvement.  Somewhat stronger economic growth and higher inflation, now that governments and corporations are joining consumers in spending once again, will push bond yields higher over the next few years.  The next significant interruption of this new trend in the fixed interest markets is likely to occur when central banks tighten monetary policy sufficiently to rein in rising inflation, possibly triggering the next global recession in the process.