Is this really the end for the long bull run in bonds?

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Please note that tax, investment, pension and ISA rules can change and the information and any views contained in this article may now be inaccurate.

Bull run

Japanese Government Bonds (JGBs) have the nickname of ‘the widow maker’ because so many traders have come unstuck trying to call the top in the JGB market over the past 25 years, generally getting themselves carried out as they shorted, or sold, Tokyo’s debt market.

Experts who look at, and investors with exposure to, the West’s Government debt markets, either through a bond fund or direct holdings, now face a similar dilemma, after an equally powerful 35-year bull run in US Treasuries, UK Gilts and German Bunds. This multi-year surge has also helped to lift prices (and lower yields) in investment-grade and ‘junk’ corporate bonds too, in the process driving many toward equities in a quest for income.

Even if no individual investor is going to short sovereign debt, they may wish to calibrate their asset allocation towards it, given the possible implications for not just fixed-income but stock markets too. After all, were Government bond yields to reach a certain level, especially relative to the yield available on equity markets, someone, somewhere may feel that the risk-reward profile even justifies a switch out of stocks and back toward bonds.

Rising tide

At the moment, the yields available on Government bonds are rising:

  • The yield on the benchmark 10-year US Treasury has reached a three-and-a-half-year high of 2.72%. The two-year yield has reached 2.13%, its highest since September 2008.

US Treasury yields are moving sharply higher

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Source: Thomson Reuters Datastream

  • In the UK, the 10-year Gilt yield is 1.47%, its highest in over a year and the two-year stands at 0.63%, its highest since late 2016.

... as are UK Gilt yields .....

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Source: Thomson Reuters Datastream

  • In Germany, the five-year Bobl’s yield reached positive territory for the first time since 2015 just this week, and the 10-year Bund yield has hit 0.65%, a two-and-a-half-year high (although the 2-year yield is still a rather perplexing minus 0.52%).

... as are German Bobl and Bund yields.

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Source: Thomson Reuters Datastream

Note from the charts how this has not happened overnight. It has instead been a case of ‘boiling frog’ syndrome: the water has been getting slowly hotter (bond yields going slowly higher), with the frog (or in this case fixed-income investor or fund manager) barely noticing at first, but the heat is now reaching a level whereby the first signs of discomfort are evident.

After all, bond prices move inversely to yields and with yields so low it only takes a small movement in prices for the capital losses to quickly exceed the value of the coupons. This raises the question of whether fixed-income assets really are the ‘safe’ option they are seen to be, with perhaps short-duration (zero to five-year) bonds offering a bolt-hole, albeit in exchange for minimal yields.

QE becomes QT

There are two possible explanations for the bond sell-off.

  • First, the markets are buying into the concept of a synchronised global recovery, where labour is in relatively short supply and wage rises may be around the corner, companies have kept capital investment (and capacity) on a tight leash, the dollar is weak and oil prices are strong. The net result could therefore be inflation – at long last – after more than a decade of worrying about disinflation or even deflation. Five-year forward inflation expectations in the USA have crept up to their highest since late 2014 at 2.23%, although such a figure suggests a lot of market participants have yet to wholly buy in to this narrative.

US inflation expectations are creeping higher

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Source: FRED - St. Louis Federal Reserve database

  • Second, two major Western central banks are tightening monetary policy and one more is running a policy that is less loose. The US Federal Reserve has already raised interest rates five times since December 2015 and it began to taper Quantitative Easing in autumn 2017. The absence of this big buyer may now be making its presence felt as the increase in US Treasury yields (and drop in prices) has become more marked since QE became Quantitative Tightening (QT). The Bank of England has raised rates once and the European Central Bank has just tapered its QE scheme for a second time, from €60 billion a month to €30 billion. The Fed, BoE and ECB are clearly going to have to tread carefully.

US Government bond sell-off has accelerated as the Federal Reserve has begun to shrink its balance sheet

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Source: Thomson Reuters Datastream, FRED – St. Louis Federal Reserve database

Tipping point

Investors with equity exposure may not feel inclined to fret about either explanation as both could be taken as a positive, since they suggest economic and corporate earnings growth could prove robust and dividend yields well underpinned.

However portfolio builders will also be well aware that a high surge in bond yields could suck cash back to fixed income and away from stocks, although where that tipping point is remains a matter of some guesswork.

  • In the US, the 10-year Treasury yield of 2.72% compares to a trailing yield of around 2.0% on the Dow Jones Industrials and 1.8% on the S&P 500, according to data from the Wall Street Journal. Both figures are eclipsed by the two-year yield of 2.13% for good measure so this is an interesting test, although it is unlikely that the bond yields are enough to tempt equity markets to switch, especially when inflation in the US is running at 2.1%.
  • In the UK, the FTSE 100 offers a dividend yield of around 4% and the All-Share of some 3.6%. Both beat the 1.47% yield on the ten-year Gilt hands down and as such the threat of a bond-to-equity switch looks less in the UK providing economic and earnings growth do not disappoint.

Blip or trend

It is the risk of economic disappointment that still forms the bull case for bonds. Global indebtedness has never been higher, having passed the $200 trillion threshold in 2017, more than a third above where it was in 2007 before the Great Financial Crisis began.

It is possible to argue that such borrowing has only pulled forward economic growth, not created it, and that a reckoning still remains, especially as demographic trends in the West are poor, in the form of low birth rates, rising numbers of pensionable workers and unfunded welfare bills. As such, future growth could prove a letdown, capping inflation and reinforcing the potential value of the fixed coupons from bonds.

In addition, the price-crushing powers of the internet could yet keep inflation low, as could a trend toward automation in the workplace, as it cows workers into keeping wage demands modest (or simply does away with the workers altogether).

The long-awaited bond market rout is therefore by no means a certainty and the latest sell-off may simply be the latest in a series of blips in a long-term trend of ever-lower yields on Government paper, to match those of 1984, 1987, 1994, 1997, 2000, 2006, 2010, 2011 and 2014.

If that does prove to be the case, it may be UK Gilts and US Treasuries which will earn the ‘widow maker’ moniker if too many traders start shorting them and investors avoid them altogether in favour of stocks or other asset classes.

US 10-year Government bonds have seen several sell-offs since 1981 .... though the downward trend has yet to be decisively broken

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Source: FRED - St. Louis Federal Reserve database

Russ Mould, AJ Bell Investment Director


russmould's picture
Written by:
Russ Mould

Russ Mould has 28 years' experience of the capital markets. He started at Scottish Equitable in 1991 as a fund manager and in 1993 he joined SG Warburg, now part of UBS investment bank, where he worked as equity analyst covering the technology sector for 12 years. Russ joined Shares in November 2005 as technology correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media by AJ Bell Group, he was appointed AJ Bell’s Investment Director in summer 2013.