As recession fears recede in the US, the golden days might be over for government bond markets

With US economic data suddenly looking brighter and positive noises being made in the trade war, risk reversals could be round the corner. After years as sanctuaries for investors, government bonds may finally lose their mojo in 2020

David Brown

Published: 3:00am, 26 Nov 2019

Why you can trust SCMP

There’s so much uncertainty about the outlook for 2020, investors may feel a sense of being on the edge of an abyss. Global economic risks, the unremitting US-China trade war and financial market worries have compounded a feeling of doom and gloom about a possible recession and market meltdown next year.

But investors could also take a leap of faith that 2020 might not turn out as feared, with risk-aversion and safe-haven trades being turned on their head.

With US economic data suddenly looking brighter, positive noises being made on the trade front and the policy environment staying extremely generous, investors could be caught napping.

There’s already speculation that equity markets could be set for a vigorous rally before the end of the year. Last week’s US business confidence numbers were better than expected, with the IHS Markit manufacturing index rallying to 52.2 in November, up from 51.3 in October and a safer distance from the boom-bust threshold of 50.

Even US service sector business activity quickened, to 51.6 in November, from 50.6 the previous month.

Recession anxieties are receding, there’s new hope that Washington and Beijing can settle their differences and markets are even sounding blasé about the potential fallout of an impeachment of US President Donald Trump. It could be a blessing in disguise if political uncertainties subside.

It means investors could be in for some surprise risk reversals. After years as sanctuaries for investors, 2020 could be the year government bond markets finally lose their Midas touch, signalling tougher times ahead for US treasuries as flight-to-quality flows go into reverse.

It could mark the end of the road for the 38-year bull market in bonds. With global investment portfolios currently looking heavily overweight in bond holdings, there is a risk of a significant market correction if the retreat from government debt turns into a rout. Long-term bond yields could be in for a protracted rise after a period of major compression.

Although rising yields mean higher borrowing costs for US consumers and businesses, it should be a relief for the Federal Reserve which has battled to normalise the US yield curve into a more settled, upward-sloping shape.

Three tiresome myths about China’s ‘incompatible’ economy and global trade

After three successive interest rate cuts this year, the Fed seems to be gaining the upper hand, as market expectations for future easing have moderated and the US Treasury curve is getting steeper and has been in positive territory in recent months.

As recession worries recede, inflation pressures build and risk premiums recover, higher bond yields and a steeper curve will follow.

Even though the short-term outlook could be volatile, it should be a win-win outcome for bond market bears as higher yields prevail. If there is a breakthrough in the US-China trade war, equity markets will rally and government bonds will sell off as safe-haven flows go into reverse.

But if the trade war drags on, Beijing could wield a very powerful weapon in the shape of a buyer’s strike against Treasury bonds or by dumping US government debt in the open market. The bond market would panic and US bond yields could surge. It would be a weapon of last resort.

Beijing’s worst nightmare? A property market collapse, Japan-style

The only question mark is the upside potential for US bond yields as the selling pressure gathers pace in the run-up to the 2020 US election next November. With impeachment pressures bearing down on Trump, the chances of generous pre-election fiscal sweeteners and the ever-widening US budget deficit should send shivers down the US Treasury market’s spine.

Benchmark 10-year US Treasury note yields could easily retrace back up to last year’s high above 3 per cent, especially if the recovery gains pace. A longer-term, higher-inflation and tougher rate policy from the Fed could put 10-year yields on a collision course with 5 per cent, a level not seen since before the 2008 crash.

Bond market investors have had a very good run for their money, but it could soon be ending.

David Brown is the chief executive of New View Economics

Post