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December was another highly volatile month for government bond markets but one which saw 10-year yields rise in unison over the month, except in Japan. Disappointment with the European Central Bank’s limited expansion of monetary policy early in the month kick started a general sell-off lifting German 10-year yields by nearly 20 basis points to 0.68%, and those in the US and UK by 15 basis points, to 2.31% and 1.92% respectively.
US, UK and German bonds all produced negative returns in December but recorded modest profits for 2015
A flight to quality followed, however, resulting in US 10-year treasury yield dropping back to 2.13% only for prices to fall again on a weak auction and a recovery in risky assets that took yields back up to 2.29% on the day the Federal Open Market Committee hiked interest rates.
Thereafter, in low volume trade, yields were little changed through to month end. In contrast, sentiment towards 10-year Japanese Government Bond’s improved and ended the month at 0.27%, their lowest yield since last January’s exceptional decline.
Ten year Government bond yields increased substantially in the US and UK in the last three months of 2015, although this followed a far greater decline in the three months prior. The 20 basis points rise principally reflected the general improvement in economic conditions and the onset of Fed monetary tightening. Over the full year rates were modestly higher.
Two year yields generally rose alongside 10-years but by more in the US. This caused the US yield curve to flatten further to 122 basis points, the lowest for eleven months and 60 basis points below the mid-year 2015 peak.
US, UK and German/EU bonds all produced negative returns in December while Japan’s All Maturities index recorded a 0.7% gain. Slightly larger losses were recorded by All Maturities in the US and UK in the fourth quarter but for the full year all markets recorded modest profits.
Of course, currency trends were once again the main contributing factor to returns with dollar strength and euro weakness drastically altering investor returns.
What Next for Government Bonds?
With somewhat stronger economic activity, headline inflation set to rise significantly from the extremely lows of 2015 and expectations of US and UK central bank tightening, yields are generally predicted to rise this year.
Average forecasts indicate a year of fairly substantial, similar losses for all the main government bond markets of between 2% and 4%.
Fair value bond models indicate government yields remain expensive. It is difficult to conceive that US yields will remain close to 2% given the economic cycle has reached the stage of near full employment, wage and salary income is growing at 4%..
Together with headline CPI inflation likely to jump from 0.2% to probably 2.0% by the end of the year, real yields will fall again close to zero. US treasuries, of course, still offer EU and Japanese investors a considerable yield pick up, as well as the prospect of currency gains which, as was seen last year, can far outweigh the importance of yield moves.
Once again, forecasts may well prove overly optimistic but current low yields appear incompatible with expected economic and interest rate trends.
UK 10-year yields traded within a -20 basis points to -40 basis points range below US 10-year treasuries for most of 2015, with the correlation remaining high irrespective of differing economic conditions, a General Election and other macro noise.
Final figures for 2015 suggest the UK economy slowed modestly but, as in the US, inflation is on the rise and the Bank of England could begin hiking rates in the summer ahead of market expectations of a much later move. Additionally, there is “Brexit” to overcome with June a likely vote date. With UK inflation-linked bonds having outperformed again in 2015, it holds few attractions at the current level of real rates.
