Los bonos han vuelto a ser bonos

Recent global bond sales have reignited concern over the sustainability of public finances. While this issue worries me in the long run, the recent weakness in the bond market should be interpreted as a continuation of the prolonged normalization after the historical anomaly of the 2010s decade. During that decade, central banks were buying trillions of dollars in public debt, reference interest rates were near zero, and sovereign financing costs remained low for years.

If someone had spent a few decades on a deserted island, current yields would seem perfectly normal at the end of their solipsistic isolation, not at crisis levels. At Deutsche Bank, our stance has consistently been that yields will rise due to strong government issuance, the withdrawal of quantitative easing bond-buying programs by central banks, and persistently higher and volatile inflation compared to the pre-pandemic period.

In the United States, inflation has exceeded the Federal Reserve's 2% target for over five years. There are positive news that have supported higher yields. Global growth has held up better than most expected since the start of the Iran conflict. U.S. nominal GDP growth in the second quarter was 6.6% year-over-year, the highest since 2005, excluding the Covid-19 spike.

While this is partly due to rising energy prices and inflation, there is no doubt that real growth is also staying strong, partly due to the continuous rise of AI. This has also increased corporate debt issuance, which has competed with government bonds for investor demand in recent months. European growth, for its part, is also behaving better than many believed possible amid the familiar energy shock hitting the continent.

And let's not forget, fiscal concerns are real, and higher financing costs could worsen debt arithmetic, especially if growth weakens. However, the most significant change is that the break-even rate for bond yields is higher than markets were accustomed in the era of ultra-loose monetary policy. This has understandably caused concern, but there is one aspect that has received little attention: investor returns are starting to stabilize and have been positive in recent months and years.

This is a welcome change compared to the beginning of the 2020s decade, when low initial yields offered no protection against market dips. Total returns over five and ten years still hover near their lowest recorded levels in many government bond markets. However, the worst of the negative return period is likely already behind us.

Over the last year, the Bloomberg US Treasury Total Return index generated positive returns even with a 0.60 percentage point increase in 10-year yields. From current levels, a 10-year yield would have to climb to around 5.5% next year, or 6.4% over two years, for total return to become negative. An investor who bought a 10-year Treasury when the yield peaked at 4.99% in October 2023 would now have a total return exceeding 16%.

This reminds us how important the initial yield is now. The United Kingdom provides an even clearer example, given the constant negative news. The 10-year government bond yield is now about 0.65 percentage points above its peak during the 2022 budget crisis. However, the general government bond index has generated approximately a 12% return since those peak crisis levels.

There has been no prolonged negative return period in government bonds over those four years. This does not mean the secular adjustment has concluded. Unless a significant revision downward of growth expectations or an external shock occurs, it is unlikely that forces driving yields up will disappear, but at least we are now back to a situation closer to normality.

Over the last 100 years, a period with frequent and significant price fluctuations, U.S. inflation averaged 3% and the U.K. 4%, levels higher than observed since 1990 but below current long-term yields. After years in which returns depended heavily on capital gains, normal yield levels now provide earnings that can be accumulated over time, helping to cushion volatility and reward patience.

Pressures will persist, and it is difficult to predict spectacular returns, especially in real terms, but at least bonds have returned to being bonds, and investors should keep this in mind when inevitable negative headlines arrive. The author is Deutsche Bank's global macro analyst and director of the Deutsche Bank Research Institute.