Government bonds sold off across the developed world last week as investors abandoned the ‘safe haven’ mindset in favour of the “great reflation trade”.
The yield on a 10-year German government bond, which moves inversely to the price, rose from an intra-day low of 0.05 per cent on April 13 to 0.8 per cent at one stage last week.
The sell-off has been mirrored in both US and UK government bonds, with the yield on a 10-year UK gilt having risen from an intra-day low of 1.5 per cent on April 13 to surpass 2 per cent last week for the first time since November 2011.
The sell-off seemed to hit a ceiling last Thursday after a 20 basis-point rise in the 10-year German bund yield in the morning was reversed by the end of the day.
But the speed and extent of the sell-off has left fixed income experts scrambling for an explanation, pointing to rising inflation expectations, renewed fears of a US rate rise, or simply that the market had become too expensive and stretched.
A major driver behind the fall in bond yields had been the fall in inflation across the developed world, which was sent lower by the plummeting price of oil.
But the price of the commodity has doubled since reaching its nadir in January, raising the spectre of inflation, which is negative for bonds.
Bryn Jones, manager of the Rathbone Strategic Bond fund, said the move higher in yields, particularly in Europe, could be seen as the start of a “great reflation trade”.
Mr Jones said the “economic surprises in Europe continue to be to the upside”, so investors could be selling off government bonds in anticipation that the region has fought off deflation, and prices will now start to rise. The markets have also been spooked by comments from US Federal Reserve chairwoman Janet Yellen last week, which seemed to indicate the US Federal Reserve was committed to raising the US base interest rate sooner rather than later, in spite of weak economic data.
A rise in the base rate is expected to be mirrored, particularly in the US, by a rise in bond yields as investors sell out.
Anthony Willis, investment manager at F&C Investments, said some government bond markets, particularly in Europe, had been operating under the “greater fool” theory – investors had only been buying the expensive debt in the belief that some ‘greater fool’ would buy it off them at a later date.
However, that trend has now evaporated and investors have been left unsure about where bond yields will now settle in this uncertain new environment.
Mr Jones said the rapid sell-off may have been exacerbated by some investors loading up short positions on German bunds because when their yields went negative “it cost zero carry – [meaning] it basically cost nothing to short bunds”.
Mark Holman, chief executive at fixed income boutique TwentyFour Asset Management, said “the rationale for those ultra-low yields has gone for now and the market is readjusting”.
He said where the yields would go from here was “hard to forecast”, but he admitted “the shorter term trend is higher and we do not want to stand in the way of that”.
