Bears’ growl is not threatening enough to end the 30-year rally in government bonds
The gradual end of monetary stimulus by the world’s top central banks and a rise in inflation are bound to put debt markets under strain
Last Friday, the yield on the benchmark 10-year US Treasury bond reached its highest since September 2014, surpassing its level in the aftermath of Donald Trump’s upset victory in America’s presidential election when international investors were positioning themselves for a surge in growth and inflation.
While the so-called “Trumpflation trade” fizzled out at the beginning of last year, it has made a comeback over the past few months as financial markets reassess the outlook for the US economy following the enactment of a sweeping tax reform package last month and a renewed increase in inflation in November.
Brighter prospects for global growth, particularly in the euro zone whose economy is expanding at its fastest pace in six years, coupled with the gradual end of the period of ultra-loose monetary policy, are fuelling speculation among traders and investors that the 30-year-long bull market in government bonds has finally run its course.
While there have been a number of false alarms over the past few years, the case for a bear market in fixed-income is growing stronger by the day.
Firstly, according to data from JPMorgan Asset Management, this year will mark the first year since the 2008 financial crisis that flows into global bond markets from the world’s four major central banks – the Federal Reserve, the European Central Bank, the Bank of Japan and the Bank of England – will turn from positive to negative. While the shift is expected to occur only at the end of this year, given that central bank support has been instrumental in lifting asset prices, the removal of monetary stimulus is bound to put debt markets under strain.
Secondly, investors have started positioning themselves for a rise in inflation, which erodes the value of bonds. A closely watched market gauge of US inflation expectations has risen to its highest level in three years. Last week, inflation-protected bond funds attracted record inflows of US$1.5 billion, marking the 13th consecutive week of inflows, according to data from EPFR Global, a data provider.
This chimes with the findings from the latest global fund manager survey by Bank of America Merrill Lynch, published last week, showing that investors’ allocation to bonds has dropped to a four-year low as money rotates into buoyant equity markets. According to the survey, a surge in inflation and a crash in debt markets are now considered to be the biggest “tail risks” in markets.
Yet if the bond bears are growling, their growl is evidently not threatening enough.
Earlier this month, Italy attracted a record €31 billion of bids in a sale of 20-year bonds issued at a yield of nearly 3 per cent. If investors are falling over themselves to buy the debt of Italy – the economy which poses the biggest threat to the euro zone because of its excessively high level of public debt and the probability that populist parties will perform well in a crucial parliamentary election in March – it is clear that bond markets remain resilient.
At a time when negative-yielding government debt still accounts for more than 15 per cent of the stock of global sovereign bonds, a modest rise in yields – the 10-year Treasury yield still remains 35 basis points below the 3 per cent level reached at the end of 2013 following the Fed-induced “taper tantrum” – is just what the doctor ordered.
According to JPMorgan, emerging market bond funds have attracted nearly US$7.5 billion of inflows since the beginning of this year, after drawing in a whopping US$113 billion for the whole of 2017, a record high. Even spreads, or the risk premium, on high-yield bonds – debt issued by companies with speculative-grade, or “junk”, credit ratings – have fallen to their lowest levels since the financial crisis.
All this suggests that investors’ appetite for global debt remains strong despite fears that the 30-year-long rally is going into reverse.
While yields on government bonds are rising – the 10-year Treasury yield is up 25 basis points since the start of this year – the increase stems from the pickup in global growth, which is buoying markets. The danger, however, as I argued in an earlier column, is that the recent rise in inflation proves much sharper than expected, forcing central banks to normalise monetary policy more rapidly.
It goes without saying that all eyes will be on inflation in the coming weeks and months. Yet for the time being, and to paraphrase Mark Twain, reports of the death of the bond bull market are greatly exaggerated.
Nicholas Spiro is a partner at Lauressa Advisory