So far this year, returns on bonds are positive, with longer duration U.S. bonds performing even better than equities. Negative sentiment on bonds had been building in concert with expectations of improved growth and higher rates. Instead, growth disappointed and rates fell, providing the catalyst for solid returns from bonds in the first half. At current levels, we once again expect bonds to deliver negative or relatively low returns unless growth disappoints in the second half.
U.S. rates may appear low in absolute terms, but compared with the rest of the developed world, they are actually higher in a relative sense than at any previous point in this cycle (Exhibit 1). The spread between the 10-year U.S. Treasury and the simple average of G7 bonds of similar maturity is 63 basis points. Returns for developed bond markets outside of the United States were generally even better than returns for U.S.
This is the continuation of The Shadows of the Bond Market's Past, Part I. If you haven't read part I, you will need to read it. Before I start, there is one more thing I want to add regarding 1994-5: the FOMC used signals from the bond markets to give themselves estimates of expected inflation. Because of that, the FOMC overdid policy, because the dominant seller of Treasuries was not focusing on the economy, but on hedging mortgage bonds. Had the FOMC paid more attention to what the real economy was doing, they would not have tightened so much or so fast. Financial markets are only weakly representative of what the real economy is doing; there's too much noise.
All that said, in 1991 the Fed also overshot policy on the other side in order to let bank balance sheets heal, so let it not be said that the