Decade-long bond rally has finally run its course
Donald Trump’s presidency may usher in the next secular, or long-term, bear market for bonds
On Tuesday, the four main stock market indices in the US, which include the benchmark S&P 500 and the tech-heavy Nasdaq Composite, simultaneously hit record highs for the second consecutive day - a performance last witnessed at the peak of the dotcom bubble in late 1999.
A staggering US$30 billion (HK$233 billion) flowed into US mutual equity funds in the week ending November 16 - the first full week of fund flow data since the stunning victory of Donald Trump in the US presidential election - according to EPFR, the financial data provider.
Yet what one hand of the financial markets giveth, the other taketh away.
In the same week, more than US$18bn was withdrawn from global bond funds - the second-largest weekly outflows since EPFR began tracking fund flows - with emerging markets accounting for just over a third of the redemptions. According to JPMorgan, emerging market bond funds suffered their sharpest weekly outflows on record.
The sharp divergence in asset prices stemming from expectations that a Trump presidency will lead to higher growth and inflation, thus forcing the Federal Reserve to raise interest rates more aggressively (futures markets are now attaching a 100 per cent probability to a rate hike next month), is fuelling speculation that the three-decade-long bull market for bonds has finally come to an end.
Henry Kaufman, the former chief economist of Salomon Brothers, known as “Dr Doom”, who correctly predicted the last bond bear market in the 1970s, believes Trump’s victory represents a regime change in global finance and politics which will lead to a gradual rise in long-term interest rates. “Secular swings are hard to forecast, but the secular sweep downwards in interest rates is over,” Kaufman told the Financial Times earlier this month.
Ray Dalio, the founder of Bridgewater, the world’s largest hedge fund group, has echoed his comments by claiming, in a post on Linkedin, that “there is a good chance that we are at one of those major reversals that last a decade” due to decreasing globalisation and free trade, expansionary fiscal policies and a surge in inflation.
But is a Trump presidency likely to usher in the next secular, or long-term, bear market for bonds?
There is certainly evidence that this may well be the case.
The yield on benchmark US 10-year Treasury bonds has surged 50 basis points since the US election to 2.35 per cent, its highest level since July 2015. The more policy-sensitive 2-year US Treasury yield, meanwhile, has shot up a dramatic 30 basis points to 1.13 per cent, its highest level since the end of 2009.
Even Japan’s 10-year yield, which was still in negative territory before Trump’s victory, has risen nearly 40 basis points to 0.033 per cent, presenting a serious challenge to the new policy of the Bank of Japan to hold the 10-year yield at zero per cent.
Yet in a sign that bond investors are conditioned to believe that yields will eventually come down again - previous bond market sell-offs have quickly reversed because of a combination of central banks’ ultra-loose monetary policies and structural constraints to faster growth - the sharp decline in bond prices is already abating somewhat.
German 10-year yields even began to fall last week.
The “reflation trade” - moving assets out of bonds and into equities in anticipation of stronger growth and rising inflation - is much more pronounced in the US than in Europe and Japan where growth is much weaker and inflation is significantly lower.
The gap between the US 10-year yield and its German equivalent has risen to more than 200 basis points, its widest level since at least 1990, according to data from Reuters. Moreover, the spread between the US 2-year yield and its German equivalent currently stands at an 11-year high.
Still, the US bond market dominates the global capital markets.
When the Treasury market sneezes, other countries’ debt markets inevitably catch a cold.
If investors believe Trump’s reflationary agenda stands a good chance of being implemented, US bond yields could rise a lot further, putting upward pressure on European and Japanese yields.
Yet the sharper the sell-off, the more wary the Fed could become about raising rates for fear of endangering growth, potentially causing the dollar and Treasury yields to decline once again.
HSBC’s fixed income research team believes the bull market for bonds has yet to end and expects the 10-year Treasury yield to fall to 1.3 per cent by the end of 2017 on the grounds that Trump’s policies “will ultimately fail to deliver.”
While this could happen, the inescapable feeling is that, this time round, the great bond bull market has finally run its course.