Economics and markets
March 21, 2022
It’s a challenging time for global fixed income. In this video interview, Vanguard Global Chief Economist Joe Davis says he doesn’t see a bear bond market on the horizon but that the odds are stacked toward lower projected returns over the next decade.
Mike Collins: Fixed income, it's a really challenging environment out there, right? Not just here in the United States, but within the global environment as well.
What do you see for the fixed income landscape playing out over the next ten years?
Joe Davis: Well the next ten years, the risk premiums, first of all, the risk premiums right now are fairly compromised, right? You have a flat yield curve, which means it's telling you that the Treasury market's assigning very little term premium or the steepness of the curve. You have credit spreads that, going into this year, were really tight. I mean, fairly compressed. And so, what does that tell you? And then, of course, we're sitting on a zero bound—short-term interest rates at zero, Mike, right?
So from a nominal as well as a real perspective, and this is before inflation even went higher, the odds were stacked towards lower projected returns. So that's not a great, novel insight, but that's what all the analytics point to.
And so it's for modest returns that are near the coupon. And I've said before, I think the Federal Reserve may be a little bit more aggressive by the end of the cycle than the bond market currently anticipates. But I want to underscore, that does not mean that there's a bond bear market on the horizon.
And I think that's why it's important to appreciate, even with the massive increase we've seen in inflation, you have the ten-year Treasury today that's roughly 2%. And that just underscores to me, that I just try to underscore that there's a number of drivers that can move interest rates. We'll have new Megatrends piece coming out soon about the other forces that move interest rates up and down that have nothing to do with growth and inflation. And they're meaningful, and it's something that has really guided our view even beyond our Federal Reserve outlook that interest rates were not going to take off to the moon even if we saw inflation pick up.
And I think the recent episode is just another reminder that's a little bit complicated and there's competing forces.
So I'm not bearish on fixed income. It's acknowledging that there is very modest expected return, but in flights of quality, I think all of us investors should be applauded for still acknowledging the ballast and the flight to quality dynamic.
And so, why I get a little bit optimistic if we can look beyond this year and see more normalization, starting with the central banks, we start to get positive real interest rates, that will start to lift our expected return projections because that's been the primary reason why we've seen a modest deterioration on our expected returns looking out, at least since 2015, 2016.
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