Bond investors continue to be challenged by the prospect of rising inflation and tighter monetary policy. The Bloomberg Barclays Global Aggregate index year to date is down 1.7% in U.S. dollars. Both investors in global government bonds and global corporate debt have lost ground as bond yields have risen and corporate credit spreads have widened.
As well as further tightening of monetary policy in the U.S., two other issues have contributed to the losses. Emerging market debt has been sold off as investors have become more aware of emerging market risk, sparked in particular by unpleasant surprises out of Argentina and Turkey, and the Bloomberg Barclays Emerging Markets Aggregate index is down 4% in U.S. dollars.
In the eurozone, investors were alarmed by the formation of an unlikely and economically radical coalition in Italy, which reawakened older fears of eurozone financial stress for holders of Italian government debt.
The 10-year Italian government bond yield, which had been around 1.75% before the election result, spiked to 3.1% on 8 June, and at its current 2.6%, is still well up on its pre-election level.
International Fixed Interest — Outlook
The macroeconomic currents continue to run against bonds as an asset class. While it has taken a much longer time than expected, a sustained global economic expansion, helped by monetary policy left on multiyear ultra supportive settings, has finally got inflation moving back up to the levels that central banks would like to see.
In the U.S., for example, the latest reading on core inflation was 2.2%, and in its latest forecasts, the Fed has said it expects core inflation to stay at 2.1% in both 2019 and 2020. Progress towards more normal inflation rates has generally been slower outside the U.S. but even in the formerly deflationary eurozone and Japan, prices are rising faster.
The latest Economist poll of international forecasters expects inflation to be 1.6% this year in the eurozone, and 1.3% in Japan. This has two consequences for bond yields. Inflation leads investors to demand higher yields to preserve their real, after inflation, return. Inflation back nearer the central banks’ targets means they can remove the previous degree of monetary stimulus.
On 13 June, the Fed raised its target range for the federal-funds rate by another 0.25%, to 1.75%–2%, and indicated there are likely to be two more 0.25% increases this year, one more than markets had been braced for.
On 14 June, the European Central Bank said it would slow down its bond purchase programme, which had been keeping bond yields down, from September, and is aiming, provided there are no economic surprises, to wind it down completely by the end of this year. Interest rate increases, however, still look some distance away, for example, according to the ECB, late 2019. As these processes work through, bond prices will remain under pressure. It is unlikely to be a rout.
U.S. forecasters in the latest poll run by the Wall Street Journal expect the 10-year U.S. Treasury bond yield to peak at 3.6% by the end of next year, and to stay around that level in 2020. That is also the level at which the fund managers surveyed by Bank of America Merrill Lynch, or BAML, would consider rotating back into bonds from equities. But until yields have plateaued, capital losses will be constraining returns from the asset class, and fund managers are unsurprisingly steering clear, with a 49% underweight allocation in the BAML survey.
Major geopolitical or financial surprises might reignite safe haven demand for bonds, but absent shocks, the economics does not look like playing out well for the asset class.
