The biggest influence on global bonds in recent weeks has been the tension over North Korea, which has led during more nervous periods to “safe haven” buying of government bonds.
In the US, for example, the yield on the benchmark 10-year Treasury note had been trading around the 2.25% mark in the first half of August, but got as low as 2.04% on September 7. There were similar North Korea-induced declines in other major bond markets, with the yield on the 10-year German government bond falling to a low of 0.30%, also September 7, and the yield on the Japanese equivalent dropping below zero, September 8.
More recently the bond markets appear to have become somewhat less worried about North Korea and yields have risen again with, for example, the US benchmark yield now just under 2.3%, not quite back to its levels before the tensions emerged. Whether the more relaxed mood will persist is unclear. With potentially more on the missiles horizon, has led to modest capital gains for bonds.
Monetary Policy Slower for Longer
While the economic fundamentals have temporarily taken a back seat to geopolitics, they have also helped the positive fixed interest outcome, with forecasters now inclined to think future monetary policy tightening, particularly in the US, will be slower and smaller than previously thought. The result is that fixed interest has done well. Year to date, in terms of unhedged US dollar total return, the Bloomberg Barclays global aggregate indices show that global government bonds have returned 7.5%, global corporate bonds 7.8%, emerging market debt also 7.8%, and global high yield 9.5%.
Where Next for US Bond Markets?
Conditions in global bond markets remain highly unusual, with investors finding very little yield on offer. In the past week, for example, the Austrian government has been able to raise €4 billion at a yield of negative 0.165%, and investors looking for a positive yield are still being forced to go to unusual lengths to find it.
Austria also issued another bond in the same week, with a 100-year maturity, on a yield of 2.1% and press reports say there was strong investor demand. Investors have also been forced into higher-risk and off-the-beaten-track options. Corporate treasurers have been delighted to supply the demand.
According to U.S. data company Dealogic, some $340 billion of high yield debt has been issued year to date, which is a 38% increase on a year ago. These unusual conditions have repeatedly wrongfooted previous expectations of bond yields moving back to more normal levels, and have persisted longer than practically anyone imagined.
That said, there is now more solid backing for the view that conditions are finally on the turn, as central banks finally start to remove the ultra-supportive monetary policy that had kept bond yields abnormally low for so long. The key central bank is the Federal Reserve, or Fed, in the US.
While US inflation has generally been running lower than preferred, and has needed more of an enduring fillip from the Fed than originally anticipated to get back to 2%, it now looks as if monetary policy will be gradually nudged further away from its present very stimulatory setting. Next month, the Fed is expected to wind back the scale of its bond buying quantitative easing, or QE, programme, which has been keeping bond yields low.
The Fed is also expected to raise interest rates a bit more from the current federal-funds rate target range of 1-1.25%, although more slowly than previously thought. Currently, the market expectation is that there is a likelihood of the next increase happening at its December meeting.
Forecasters consequently expect a gradual rise in bond yields, with the latest Wall Street Journal poll of US economic forecasters expecting the 10-year Treasury yield to rise to 2.6% by the end of this year and to 3.0% by the end of 2018.
What About the Bank of England?
The Bank of England is also moving towards tightening. Unusually, it is a rare example of a central bank where inflation is above the official target – 2.9% in August compared with the BoE’s target 2%, and with unemployment at its lowest since 1975 in the May-July quarter - the bank said at its September 14 policy meeting that “some withdrawal of monetary stimulus is likely to be appropriate over the coming months in order to return inflation sustainably to target.”
The futures market now expects a 0.25% increase before the end of this year, whereas before the latest meeting, it had expected the first increase to come sometime in the back end of 2018. The European Central Bank, or ECB, does not have the same inflation problem with eurozone inflation at 1.5% in August, below the ECB’s 2% target, but given the improvement in the eurozone economy, it too has started to feel that ultra-supportive monetary policy is no longer needed. It has said that it will announce its plans for winding back its QE programme at its October policy meeting.
Forecasters think the ECB is likely to taper, that is gradually reduce, the amount of bonds it buys each month over the course of 2018, and may not be buying any more bonds at all by end of year. Geopolitics might yet throw a large spanner into the works, and monetary policy might not be able to proceed in the nice orderly fashion currently expected.
But if it is, of the major central banks, only the Bank of Japan looks set to continue with indefinitely easy monetary policy: the others will be carefully, and gradually, moving from very easy policy to less so. The good news for investors is that modestly higher yields are on the foreseeable horizon, with the bad news that it will take a period of capital losses to get there.
