Medieval Wisdom on When to Start Worrying About the Bond Market

(Bloomberg View) -- Is the bond rally finally over? In the past six months, 10-year Treasury yields have crept steadily upward. A handful of prognosticators have seized on these developments to argue that a fixed-income apocalypse is around the corner, though most maintain that the bull market in bonds is nowhere near ending.

While it’s fun to play the prediction game, it may be more fruitful to ask something else: How does this bond rally compare to others throughout history? Does the past shed any light on what we’re likely to face?

There has been very little academic research on bond market reversals. That probably reflects the fact that bond markets are, well, kind of boring compared to the spectacular booms and busts that characterize equity markets. Bond markets also tend to suffer from inertia, drifting in one direction for a long, long time: The current bull market in bonds has been puttering along since the early 1980s.

Paul Schmelzing, a doctoral candidate in history at Harvard University, recently published a Bank of England working paper that sought to remedy this dearth of information. He began with the work of Sidney Homer and Richard Sylla, whose monumental tome “A History of Interest Rates” contains a wealth of data going back centuries.

Schmelzing then identified bonds traded on the open market that qualified as “risk-free,” long-term sovereign debt. He focused on 10-year yields because a decade was “the most liquid long-term maturity point in pre-modern times,” enabling the construction of an index that goes all the way back to the year 1273. The index eventually included debt issued by Italian city-states in the Middle Ages; Spain during its Golden Age; and, more recently, the Netherlands, Britain, Germany and the U.S.

No definition exists of what constitutes a bull market in bonds, so Schmelzing created one: a compression of the risk-free rate in headline yields of at least 5 basis points per year over a period of at least 10 years. That same market would become a bear market if the three-year moving average yield crossed the eight-year moving average yield (this was done to factor out short-term reversals).

This model is arbitrary, perhaps, but no less so than the criteria used to define a bull or bear market in equities. It yields nine nominal secular (long-term) bull markets in risk-free government bonds since the year 1273. These tend to be more numerous in medieval and early modern times, becoming somewhat rare since the late 17th century (there have only been three such bull markets in the past 200 years).

In nominal terms, the current bull market is distinctly unusual. The average length of bull markets is 25.8 years, but the current bull market is already well past that marker. Far more telling, though, is what Schmelzing calls the “intensity” of bull markets: the total compression in yield over the course of the rally. In nominal terms, the intensity of the current bull market will soon surpass the top-ranked rally, which stretched from 1441 to 1481.

This sound a little terrifying -- knowing that we haven’t seen a bond rally like this since the times of medieval Venice should give anyone pause -- but these are the changes in nominal rates, not real rates. When Schmelzing calculated real rates using various inflation proxies (see the paper for more details), he found both good news and cause for concern.

The good news is that once you factor in inflation, the current bond rally is not the most intense; in fact, it’s the least intense, and looks pretty tame relative to some of the bigger bloodbaths in the medieval bond market. (Bond wonks eager for more information should check out Chart 5 in a blog post that expanded on the original paper.)

But there are a few caveats. First, changes in real rates have become more muted over time, especially in the past century, fluctuating within a narrower band than in the medieval and early modern eras. Put differently, a basis point now may not be the same as a basis point centuries ago. As Schmelzing put it in an email to me: “One could make the case that even seemingly small changes in real rates could increasingly signal something important, and mark a new transition to a different growth environment (while further falls are equally more consequential than previously).”

Moreover, if we’ve actually hit the trough in real rates -- an open question, admittedly -- the historical record suggests that they can rise rather quickly indeed. Alan Greenspan’s warning last summer that they could rise “reasonably fast” struck many as alarmist, but in the episodes that Schmelzing studied, real rates rose an average of 315 basis points in the 24 months after the trough.

That’s not necessarily a bad thing. In modern times, bond market reversals have gone hand in hand with new bursts of economic dynamism. For example, the end of a bond rally around 1903 coincided with an escape from the so-called “Long Depression” of the 1880s and 1890s, while the demise of the bond rally circa 1948 augured postwar prosperity. In short, if the bull market in bonds ends, it may signal a new era of prosperity.

Keep in mind, though, that most bull markets don’t end this way. In fact, as Schmelzing noted in a follow-up to this working paper, “most of the eight previous cyclical ‘real rate depressions’ were eventually disrupted by geopolitical events or catastrophes, with several -- such as the Black Death, the Thirty Years War, or World War Two -- combining both demographic, and geopolitical inflections.”

So, yes: A little anxiety about rising interest rates is in order. Let us hope that is the only thing we have to worry about in the coming months and years.  

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Stephen Mihm, an associate professor of history at the University of Georgia, is a contributor to Bloomberg View.

To contact the author of this story: Stephen Mihm at smihm1@bloomberg.net.

To contact the editor responsible for this story: Brooke Sample at bsample1@bloomberg.net.

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