The bond markets, particularly in the U.S., have played a key role in the recent global financial market volatility. In the US, the key benchmark – the yield on the 10-year U.S. Treasury bond – is now almost a full half a percent higher since the start of the year, having risen from 2.4% to just under 2.9%.
Other than in Japan, where monetary policy remains set on highly supportive, bond yields elsewhere have also risen: The 10-year government bond yield in Germany, for example, is up by a fourth of a percentage point to 0.7%, and in the UK, the equivalent yield is up 0.4% to 1.6%. The Swiss 10-year yield, which last year was negative, has moved further into positive territory. Investors in fixed interest have consequently faced difficult conditions.
The headline results in US dollar terms for the Bloomberg Barclays global indexes do not quite capture the setback, as the outcome includes foreign exchange gains from holding non-USD bonds when the USD has been weak: The Global Aggregate, for example, is up 1.0% for the year to date in USD terms.
But even in USD terms some of the Bloomberg Barclays indexes are now showing losses for the year; Global Corporate Bonds down 0.6%, the Emerging Markets Aggregate down 1.6%, long maturity U.S. Treasuries down 6.3%. Many investors will be experiencing losses when hedged back into their domestic currencies.
What is the Outlook?
The proximate cause of the US bond market sell-off was evidence that wages and prices have started to pick up after a long period when they had both been surprisingly low given the strength of the US economy. If there was one single catalyst for the bond market sell-off and the associated equity volatility in February, it was the news on February 2 that average hourly earnings in the US in January were running 2.9% higher than a year earlier, more than forecasters had been expecting.
The subsequent release on February 14 of the January consumer price index cemented the idea that the period of very low wage and price growth was winding down. The headline annual inflation rate was 2.1%, and the more important “core”; excluding food and energy, rate was 1.8%.
The latest data, in short, strongly suggested that the Fed had done enough to work inflation up to its target 2.0%, that monetary policy could be tightened from where it had previously needed to be, and that bond yields would need to rise to reflect the higher inflation rate. Forecasters, and the futures markets, are now firmly of the view that the Fed will raise short-term interest rates a number of times this year.
The latest Wall Street Journal poll of US forecasters, for example, expects the Fed’s target range for the fed-funds rate – currently a range of 1.25% to 1.5% – to be raised to a range of 2% to 2.25% by the end of this year, incorporating three 0.25% hikes. Longer-term yields are also likely to rise further.
The Wall Street Journal panel expects American inflation to be running at 2.2% to 2.3% a year over the next couple of years, which means that bond yields will need to be comfortably above current levels to offer a ”real”, above inflation, return. The WSJ panel expects the U.S. 10-year Treasury yield to reach 3.1% by the end of this year and to rise a bit further to 3.5% by the end of 2019.
Inflationary pressures are a good deal less in the eurozone and Japan, and their central banks and bond markets are still a long way from needing to follow the US lead. But with the global economy outside the US also picking up steam, the need for ultra-low short- and long-term interest rates in the rest of the world is also becoming progressively less compelling.
Absent geopolitical or other shocks that might resurrect ”safe haven” buying, these are likely to be difficult market conditions for fixed interest. It is no surprise that in the latest Bank of America Merrill Lynch survey of fund managers, a net 69% have underweights to bonds, the largest proportion in the survey’s 20-year history.
