OpinionSep 10 2014

Fear and loathing on global bond markets

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In the novel by Hunter S Thompson, Fear and Loathing in Las Vegas, Raoul Duke and his trusted lawyer go on a mind-bending trip to Las Vegas under the guise of covering the Mint 400 motorcycle race for Rolling Stone magazine.

In the book, nothing is as it seems – which has odd parallels with how the bond market has performed this year, going against many investors’ expectations. Moreover, the book’s title may sum up the attitude of many investors towards bond markets right now. Fear over what might happen if yields on government bonds continue to decline in the face of stronger economies in both the UK and US, and investors loathing that they may have missed out on this seemingly unexpected rally.

One of the biggest surprises for investors this year has been the strength of the bond market and the continued decline in yields. This has led many investors to reassess previous expectations they had of yields being higher as 2014 draws to a close. At the beginning of the year, global economic growth looked like it was beginning to recover, even though there were still concerns over the strength of the eurozone. Meanwhile, after the stellar performance of developed market equities in 2013, a pull-back was widely expected. Talk soon turned to when central banks would signal an end to years of extraordinarily loose monetary policy – namely the end of quantitative easing and the timing of the first interest-rate hikes in the US and UK – and that this would lead to rising government bond yields.

Nine months on, investors probably find themselves wondering how the story will end. After all, the S&P 500 Index has broken through 2000 for the first time, and it has been more than 1000 days since the US equity market had its last 10 per cent correction, while the yield on the US 10-year Treasury fell to 2.34 per cent at the end of August, its lowest level this year.

The biggest puzzle is that yields in the US are falling as the economy gets stronger. Economic growth in the second quarter was revised up to 4.2 per cent from the initial 4.0 per cent estimate, and the momentum looks to continue into the rest of the year. There have been strong gains in both the manufacturing and housing markets, which were areas of weakness earlier in the year. The August print of the Institute for Supply Management manufacturing survey was very strong, while US pending home sales reached their highest level since last August. There may be another robust September labour market report – at the time of writing, over 200,000 jobs are expected to be added to the payroll’s number, which would make it the sixth month in a row that payrolls will have beaten that figure, and the unemployment rate is anticipated to tick down to 6.1 per cent.

The biggest puzzle is that yields in the US are falling as the economy gets stronger.

So, why are yields falling? There has been artificial demand for high-quality fixed income by pension funds for liability-matching purposes, and by banks that are being required to hold better-quality capital. However, much of the recent decline in yields may have more to do with the eurozone, and specifically, that falling eurozone inflation expectations are supporting growing sentiment that the European Central Bank’s hand will be forced into implementing a programme of quantitative easing. The sharp downward shift in European bond yields has made the yield on US Treasuries look relatively attractive for the yield-hungry investor, despite it being at very low absolute levels.

There are still many reasons why yields could be expected to move higher by year end. The Federal Reserve has systematically tapered its $85bn (£51.7bn) in monthly bond purchases by $10bn (£6bn) per month since January and, come October, the final $15bn (£9bn) round of purchases is likely to be completed. This should reduce some of the artificial demand that has supported the market. But, more importantly, with a stronger economy, and an inflation rate that is more likely to rise than fall, the expectation should be that US rate rises are on the way, and perhaps sooner than the market currently thinks, especially if the labour market continues to tighten faster than currently expected.

Foreign investors may also be expecting Treasuries to continue to outperform by betting on a stronger US dollar. It has been said that trying to predict currencies is a game for mugs, and investors may get caught out if currencies have already priced in a large amount of the pessimism regarding the eurozone economy. For now, I would be sceptical of the advice of Raoul Duke to “buy the ticket, take the ride”.

Kerry Craig is global market strategist of JP Morgan Asset Management