Where will bond yields settle when the storm is over?

Policy meddling is a wildcard that can't be predicted. But demographics clearly point to declining yields.

Disclaimer: The information contained in this article is not and should not be construed as investment advice. This is my investing journey and I simply share what I do and why I do that for educational and entertainment purposes.

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TLDR Summary

• When left alone by policymakers, long dated government bond yields typically gravitate towards the nominal growth rate of the domestic economy. Predicting the economy therefore means predicting bond yields.

• What we are currently witnessing in the economy is still the echo of the pandemic stimuli. Economic growth rates are far in excess of historical precedents, especially considering the demographic environment we live in. Nominal US GDP has advanced by 6.2% annually since 2020, which is significantly higher than during the 2010s (4.1%) and even higher than during the lead-up to the GFC from 2003 to 2007 (5.7%). This robust growth is driven by an unprecedented acceleration of deficit spending. Real GDP growth adjusted for deficit spending is in fact trailing most historical periods.

• It is hard to predict future manipulations that policymakers have in store for us. I do have an inkling that the recent inflation surge will serve as invisible handcuffs for them for the foreseeable future. They will be cautious about new fiscal and monetary stimulus. It’s just not that popular anymore. But I don’t have much conviction in that suspicion. I do know however that ceteris paribus economic growth is primarily a function of the growth rate of the productive age population. The more the productive age group grows, the more economic output grows, the more opportunities for businesses to thrive, the more investment opportunities available and the higher the natural interest rate in the economy that creditors can charge.

• The growth rate of the productive age population is therefore a pacemaker for the growth of the economy. Cyclical deviations are possible, primarily due to innovation and liquidity impulses. Aside from these cyclical deviations, the economic potential of the US economy seems much lower than what current rates suggest.

• We are still in the middle of digesting the pandemic spending binge and have likely not even seen the full potential yet. However, a return to a much lower yield environment seems likely. I have a time horizon of about 3-5 years in mind when I make that prediction.

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Status Quo

I remember a chilly day in downtown Toronto in March 2020. It was the middle of the day, but the office was fairly empty. Most people were home due to the current thing. I was sitting in my boss’ office and we were pondering about the consequences of this unique moment. At that time, huge government stimulus packages were brought on the way around the globe, which eventually proved to be only the initial drops of a much bigger wave later. I remember how I said to him that these stimulus packages were game changing because they would likely affect the economy until long after the current crisis was already resolved.