Why everybody was wrong in calling the bond market

In the days and weeks following Donald Trump’s upset victory in the US presidential election in early November, the talk in financial markets was of a “regime change” in asset allocation. Trump’s reflationary economic policies would, it was claimed, trigger a “great rotation” out of fixed income and into equities in anticipation of stronger growth and inflation.

For a month or so following the election, the “Trumpflation trade” was in full swing.

In November, the Bloomberg Barclays Global Aggregate bond index lost a whopping US$1.7 trillion, its worst performance since 1990, as the yield on benchmark US 10-year Treasury bonds surged 55 basis points between November 8, the date of the election, and November 30.

The sell-off in bonds continued for most of December, with the 10-year yield hitting 2.6 per cent on December 15, its highest level since September 2014, amid a surge in speculative bets that Treasury prices would continue falling.

Yet since mid-December, the 10-year yield has moved sideways, and has even fallen more than 30 basis points since the Federal Reserve’s decision on March 15 to refrain from accelerating the pace of monetary tightening this year.

The much-feared bear market in bonds has yet to materialise.

This would not be the first time that investment strategists calling an end to the 30-year-long bull run for fixed income misjudged the market.

Previous sell-offs in the bond market over the past several years, in particular the spike in yields caused by the Federal Reserve’s unexpected decision in May 2013 to begin winding down its programme of quantitative easing (QE),were followed by sharp rallies.

This time round, however, the catalysts for a secular, or long-term, bear market in bonds have stronger foundations, making the recent decline in yields that much more perplexing.

Part of the reason why the bond market has rallied over the past month or so is because the Trump administration is struggling to advance its reflationary agenda as Congressional support for Trump’s economic policies, in particular tax reform, proves more difficult than previously envisaged. Investors are questioning the political underpinnings of the “Trump trade”.

Another reason why bonds have risen is because the Fed has decided not to accelerate the pace of monetary tightening, unconvinced that growth and inflation are about to pick up sharply. It may well be right. According to Reuters, measures of US inflation expectations have fallen to their lowest levels in four months. In the euro zone, meanwhile, core inflation in March fell to 0.7 per cent, its lowest reading since April 2016 and a sign of the extent to which inflationary pressures across the bloc remain subdued. Even in China, price pressures are easing. Data published on Wednesday showed that growth in producer and consumer prices slowed last month.

Other factors keeping bond yields low include aggressive monetary stimulus in Europe and Japan and, more importantly, structural challenges facing advanced economies, notably ageing populations and a global “savings glut”.

Still, the bond bears may yet be vindicated.

For starters, the Trump trade is by no means dead and buried. According to Bank of America Merrill Lynch, the failure to pass health-care reform last month increases the chances that tax reform will be passed later this year since the Republicans in Congress “cannot afford another major failure before the mid-term elections of 2018”. Growing confidence that some form of fiscal stimulus will be enacted will put pressure on the Fed to quicken the pace of rate hikes, driving up bond yields.

Secondly, and more importantly, bond markets may be underestimating the severity of the fallout from the Fed’s plans to tighten monetary policy. The US central bank’s plans to begin winding down its US$4.3 trillion portfolio of mortgage and Treasury securities will remove one of the biggest sources of support for global debt markets, fuelling volatility and increasing the scope for a surge in yields.

Another reason why Treasury yields may start rising again is the likelihood that European, and even Japanese, debt will become more attractive if yields continue to rise, drawing investors away from US bonds, thereby pushing up yields.

Still, if geopolitical tensions, particularly in the Korean peninsula, escalate further in the coming days and weeks, Treasury yields will decline further as investors rush into so-called haven assets.

On Wednesday, the yield on 10-year Treasuries fell to 2.28 per cent, its lowest level since mid-November.

The bond bears may yet be proven right, but for now the bulls are sitting pretty.

Nicholas Spiro is a partner at Lauressa Advisory