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

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 advisers and clients with exposure to, the West’s Government debt markets, either through a bond fund or via 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 adviser or client 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

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 .....

Source: Thomson Reuters Datastream

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

... as are German Bobl and Bund yields.

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 of 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

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

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

Bond market curveball

Besides studying Government bond yields and forward inflation expectations, advisers and clients have a third indicator to follow as they assess their fixed-income exposure.

This is the so-called yield curve, where the yields on different maturities on bonds issued by the same sovereign Government are compared. Usually, the longer the maturity date on the bond, the higher the coupon, to compensate for the risk offered by the longer holding period.

In general terms, the yield curve has three classic shapes:

  • Steep or steepening, whereby longer-term bond yields are higher than those available from near term paper. This is really how it should be, given the relative risk profiles and when economies are doing well – or expected to gather momentum – long-term yields can rise faster than short-term ones, steepening the curve.
  • Flattening, whereby the premium yield available on longer-term paper starts to shrink.
    • A ‘bull’ flattener occurs when short-term yields are rising faster than long-term ones, as the economy and corporate earnings gather traction. At this time of the cycle, stocks, and especially cyclical areas like mining, industrials and retailers, do well, alongside commodities, while bonds start to struggle.
    • A ‘bear’ flattener develops when long-term rates are falling faster than short-term ones, as the market prices in interest rate cuts in anticipation of an economic slowdown. At this stage of the cycle bonds and defensive equity sectors like utilities, pharmaceuticals, telecoms and consumer staples have traditionally done best.
  • Inverted, whereby the yield on long-term bonds goes underneath that of short-term paper as the market prices in a deep economic slowdown, interest rate cuts and even a recession. Cash and bonds have tended to do best here, with equity income faring relatively well compared to other strategies (with the emphasis on relatively).

According to the difference between two-year and 10-year paper, which is known as the 2s-10s spread, the US and UK bond markets look to be offering up a classic ‘bull flattener,’ while Germany looks to be offering a straightforward ‘steepener.’

The gap is closing because the yield on 2-year paper is rising faster than that on 10-year, as markets price in faster growth, rising inflation and higher interest rates.

US, UK and German Government bond markets look to be pricing in faster growth and higher inflation as they show classic ‘bull flattener’ characteristics

Source: Thomson Reuters Datastream

Advisers and clients with equity exposure are likely to welcome such themes, although they will be well aware of how a surge in bond yields could suck cash back to fixed income and away from stocks.

  • 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 10-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.

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. 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 advisers and clients 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

Source: FRED - St. Louis Federal Reserve database

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine 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 as AJ Bell’s Investment Director in summer 2013.

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