The first few weeks of 2014 were a pleasant surprise for many bond investors, as benchmark yields unexpectedly fell back to levels last seen in October. But why has there been this somersault and will markets flip-flap again?
Before turning to the key fundamentals for bond investors, such as growth, inflation expectations and the official rate structure, we need to look at another driver – positioning.
At the end of 2013, most investors were looking for opportunities to add risk assets to their portfolios. Hence the shock from the emerging market turmoil that caught attention in January. The ‘fragile five’ of last summer – Brazil, India, Indonesia, South Africa and Turkey – were joined by a dozen or so countries in various forms of trouble, such as Argentina, Thailand and the Ukraine.
Analysis of cross-border flows shows retail investors quickly pulled out of emerging market assets and bought defensive equities and bonds. One investment bank reported in mid-February that the three currencies with the largest overweight positions were the US dollar, sterling and the Swiss franc, all classic safe havens.
At the same time, there was a fundamental justification to buy bonds – a reappraisal of the short-term outlook for the US economy.
The two culprits were a weaker than expected ISM manufacturing survey and payrolls report for January. Both must be taken with a degree of caution, reflecting unusually bad winter weather across large parts of the US. However, there is an underlying weakness as well.
Many US firms built up inventory in the second half of 2013 and were unpleasantly surprised when final demand was not as strong as hoped for. A classic example would be cars. Sales on an annualised basis picked up to 16 million units in the autumn, but have recently fallen back towards 15 million. Firms such as Ford have been left with excess stock, which they are now clearing with hefty discounts.
So US government bonds were well bid into February by a combination of safe haven flows and a reappraisal of the immediate economic outlook, noticeably dampening interest rate expectations.
Let us now return to longer-term drivers. Although GDP growth may be close to 2 per cent a year in Q1, there are few signs yet that the US won’t recover through 2014-15. The credit cycle, housing fundamentals, replacement investment and fiscal policy all remain supportive. While attention has focused on some weak US data, other parts of the world remain strong – for example the UK, Japan and China – or even improving, especially Europe.
Emerging market economies are dampened, but the trade links are too small to have a material impact on the developed world – on the key assumption that China remains stable, of course.
Next are inflation expectations. There are dis-inflationary aspects to the current recovery, for example less emerging market demand for commodities. However, the key issue is wages in general, unit labour costs to be more precise, and here the backdrop is less sanguine.
As unemployment in the US and UK falls towards the ‘natural rate’, these central banks will turn towards policy tightening. The market is pricing in moves by summer 2015, which makes sense on the basis of current knowledge. Tapering looks on course, after all many central bankers remain concerned about the adverse effects from unconventional policies such as QE. A major question for bond investors in 2014 then is: who will buy all that government debt if the central bank is not doing so, or more accurately at what yield will bonds have to be sold at?