Bond market bulls and bears are prowling in the dark
David Brown says bond yields lack direction in a market dominated by unpredictable developments featuring Donald Trump, trade tensions and a dawdling Fed
The mystery of where US bond yields are heading in the future is deepening by the day. With the US Federal Reserve committed to withdrawing its super-stimulus, the US economy reaching full employment, inflation set to rise and the world being dragged into a deepening trade war, bond market pundits are suddenly shrouded in doubt. Where on Earth are bond yields heading?
Back in 2013, when the Fed first announced its intention to wind down its large-scale bond-buying programme and bring its zero interest rate policy to an end, it was all crystal clear to the markets. A new era would dawn for higher rates and yields, putting a rally that was three decades old into sharp reverse. Then it was just a matter of picking waypoints on the return journey home to higher yields as the bond market braced for stronger recovery, higher inflation and a tougher Fed ahead.
But it has not been an easy road to follow. Doubts about the US recovery’s sustainability, inflation’s non-appearance and a dawdling Fed have often left investors at sixes and sevens. US bond yields have been trending higher since the bottom of the cycle in mid-2016, but market momentum has looked like it has had a mountain to climb in recent months, lacking conviction and stamina.
Right now, the outlook for fixed income seems about as clear as mud. A mishmash of conflicting economic and political forces has posed huge challenges for investors. Bond bears remain fixated by Phillips curve dynamics and full employment and higher inflation leading the way to higher rates and yields. But the bulls say there is a new show in town which could still turn yields the other way.
The ratcheting up of trade tensions between the US and China has definitely thrown a screwball at investors. It is a classic case of bad timing for a global recovery just getting into its stride. It may be too early to judge the economic impact of trade sanctions on world trade, global growth and inflation just yet, but the worry is the politics of brinkmanship will ultimately end in tears.
Markets may be holding out hope for some sort of political compromise, but recent salvoes between the US and China hardly lessen fears that the world is sliding into a bitter trade war. If that is the case, global financial stability goes up in smoke. If the row deepens, the knee-jerk reaction will be heightened risk aversion and investors dumping equities in favour of safe haven government debt.
But there is another spin to consider. The US bond market could suffer bad collateral damage if the crisis spills over into a buyer’s strike with China boycotting US Treasuries. China has a strong hand to play, holding just under a fifth of all US Treasury bonds owned by overseas investors. It could prove critical for sentiment, especially now the Fed is pulling back as the dominant US bond market player.
What complicates matters even more for the bond market is the new head at the helm of the US Fed. Fed Chairman Jerome Powell is untried and untested in the intricacies of manoeuvring a massive sea-change in policy direction, let alone at a crucial moment when the US economy could be entering into another perilous period of risk thanks to growing trade frictions.
The risks are especially high, not least because US President Donald Trump is hardly even thinking about the consequences for US soybean and hog farmers caught in the crossfire of damaging trade sanctions. The dangers for US bond market investors would come even lower down the list of the president’s priorities.
US bond markets are caught between a rock and a hard place. Over the next few weeks, investors run into a high stakes game as markets contend with a rush of US corporate results. Coming on the back of Trump’s tax cuts, expectations will be high for corporate America to show its best quarterly profits growth for years. If it fails to transpire, then equities will get hit hard.
The large build-up of net speculative positions in the US futures market would leave bond investors and traders critically vulnerable to short-covering risks.
With the jury out on trade wars, bond market investors look set for testing times ahead.
David Brown is chief executive of New View Economics