After the Federal Reserve hiked interest rates for the eighth time to 2-2.25% on Wednesday, US bond yields ticked higher. The 10-year yield ticked up at 3.069% and stays near seven-year highs. In the year to date, the yield has risen by over 25%.
This has important ramifications for investor positioning. The higher the yield on the 10-year Treasury, the less attractive equities become as the income produced by US Government debt is safer than the risk you take investing in equities.
However, rotate into bonds too early and you could lose money. Bond yields move inversely to prices, so if the coupon is increasing, the price of your bond is decreasing. Of course, that matters less if investors hold the bonds to maturity.
Rising yields have clearly improved the attractiveness of US bonds on both an absolute and a relative basis, according to Witold Bahrke, senior macro strategist at Nordea Asset Management. “It is very difficult to ignore US fixed income,” he says.
Safe Haven Status
Treasuries are known as a safe haven mainly due to the United States government’s high creditworthiness, the fact they are denominated in US dollars – the world’s reserve currency – and the negative correlation bonds tend to have to equities.
However, there are good reasons to think this may end soon, which “could have profound implication for portfolio construction”, Arif Husain, manager of the T. Rowe Price Dynamic Global Bond fund, says.
First, US debt levels are rising, thanks in part to a widening budget gap that has been stretched by the Donald Trump administration’s tax cuts and spending increases. The US is predicted to issue $769 billion of debt in the second half of 2018, the most since the second half of 2008.
The fact that the Fed, hitherto the biggest buyers of Treasuries, is now reducing its balance sheet and tightening monetary policy; while foreign institutional investors are also expected to buy fewer bonds.
Second, the decline in the US dollar’s position as the world’s leading reserve currency would also erode its safe-haven status, according to Adrien Pichoud, chief economist at SYZ Asset Management. Some believe this will happen in the coming years, or decades, with China predicted to become the world’s financial hegemon. The yuan could challenge the dollar should that play out.
Third, we saw earlier in the year that bonds’ relationship with equities looks to have broken down. Before, when stock markets corrected, investors could count on the fixed income part of their portfolios to limit the damage, as bonds tended to appreciate when stocks depreciated.
However, in early 2018 the S&P 500 fell 10.2% at the same time as 10-year Treasuries dropped 1.5%. “This positive correlation persisted for the whole of the first quarter,” notes Husain.
Finally, the potential trade war is posited as one reason for the positive correlation between bonds and equities by Husain. He cautions that Trump’s unconventional Presidential style could “raise mild concerns about the creditworthiness of the US”.
But Husain notes that these developments will be long-term in nature and the belief that US government debt is the safest available is likely to remain strong for some time.
“As such, if the next downturn occurs as expected in the next few years, it is likely reasuries will again fulfil the traditional safe-haven role,” he adds.
“However, investors planning further ahead may benefit from re-examining the role treasuries play in portfolios and asking whether the asset will continue to work as effectively in the future.”
Where Else to Look in Fixed Income?
Both Husain and Pichoud suggest German bunds could be the obvious replacement for US treasuries. “This is underpinned by the assumption a euro breakup would lead to a redenomination of the almighty Deutsche mark,” explains Pichoud.
Pichoud adds that bonds issued by governments with robust public finances like Switzerland – the Swiss franc is already thought of as a safe haven asset – Singapore or Denmark could work. However, “the size of these markets and currency risks limit their use in practise.
If the yuan is likely to displace the US dollar, of course, it could be Chinese government bonds that replace treasuries. “But major questions remain about their liquidity and accessibility, and also about the creditworthiness of the Chinese government,” counters Husain.
Husain concludes that “it is possible no country’s sovereign bonds will be considered completely risk-free in the future”. Should that be the case, investors will have to decide which other asset could take their place.
“Given the vital importance of finding anchors during times of stress, it may be worth asking sooner rather than later.”
