Investors in government bonds have faced a more challenging environment in recent months. Yields have risen across a range of markets, with investors moving to price in higher inflation and the potential for a faster pace of rate rises. Indeed, the rise in yields has led some investors to claim that we are now witnessing the end of the 35-year bond bull market.
Although it makes for dramatic headlines, an end to the bull market in bonds need not mean disaster for investors. In fact, structural forces such as high indebtedness, ageing populations, and low productivity will probably put a cap on how far yields are likely to rise. And while an end to the bull market may mean lower returns, it does not imply a bear market in bonds, where we see long periods of negative returns.
Should advisers care if we are witnessing the end of the bond bull market? Many will have a large number of retired clients who rely on their savings to provide an income. If yields on cash or government bonds rise, this might not be a bad thing, providing poorer bond market performance can be offset or mitigated. Indeed, if income investors can gradually rebalance out of equities and into more defensive areas of fixed income bonds, this could be better for them in the long term.
An environment of rapidly rising rates, however, might not allow for this gradual rebalancing. If yields rise too quickly, equity markets will reprice on the back of a higher discount rate. While this is not our most likely scenario, it does represent one of our key risks.
In the US, risks come from the Federal Reserve reducing its balance sheet built up during its various quantitative easing programmes. The central bank is now shrinking its balance sheet by letting assets mature. At the same time, the Trump administration is planning an almost unprecedented increase in the federal deficit, with tax reform having been passed in December last year, and congress more recently agreeing to spend an extra $300bn (£218bn) over the next two years.
Factoring in the Fed’s actions, together with similar assumptions around the impact of higher Treasury issuance, we believe US Treasury yields could rise by around 40-80 basis points over 2018/2019, in addition to the potential rise in yields that comes with growth and inflation at around these levels. Even the lower end of that range represents a meaningful shift when you consider that 10-year yields are currently around 2.8 per cent.
There is also upside pressure on UK gilts yields, with the economy facing above target inflation and the Bank of England appearing to turn more hawkish. However, it remains to be seen how a final UK-EU trade deal will impact growth, and although the government has relaxed its deficit reduction programme, it is not planning the type of spending increase seen in the US.
While we can estimate how high yields might have to go, the impact on equities is hard to estimate and depends how fast the rise occurs. As long as growth remained robust, we would probably see a continued grind upwards in equity markets, potentially with a rotation in the types of stocks outperforming. But if we see a large and fast move up in yields, then there is potential for both bond and equity markets to perform poorly.