The sell-off in government bonds that began in January is likely to continue as central banks reverse the policy of quantitative easing (QE), according to James Foster, who runs the £1.2bn Artemis Strategic Bond fund.
Mr Foster has a “short position” in German and US government bonds, that is, he has invested in such a way as to mean he will make a profit if the price of those assets falls.
He said the European Central Bank (ECB) halved the amount of cash it has spent on bonds, from €60bn (£53bn) per month to €30bn (£27bn) per month, in January, which promptly sent bond yields higher.
The yield on bonds rises when the price falls.
The price of the government bonds has fallen because a significant buyer of those bonds, the European Central Bank, is buying fewer bonds. So the supply of bonds hasn’t been reduced, but the demand for bonds has, forcing those issuing new bonds to take a lower price, which forces the yield upwards.
Mr Foster said: “Despite some sharp moves in government bonds, we remain very cautious.
"January marks the start of quantitative easing (QE) being scaled back in Europe and the timing of further reductions is being debated. Meanwhile, interest rates in the US will continue to rise.
"US unemployment is at historic lows. That will increase wage inflation – and ultimately inflation – in time. We feel that government bonds may well come under further pressure as a result.”
Chris Higham, who jointly runs the £592m Aviva Investors Strategic Bond fund, said that while central banks are reducing their bond buying programmes, government’s have not reduced their desire to issue new bonds.
Tax cuts in the US mean the Trump administration will have to increase its issuance of bonds, while the UK government’s “austerity” programme of spending cuts has been reduced somewhat as the country’s exit from the European Union looms, he said.
That also requires the issuing of more bonds, at a time when central banks.
Mr Higham feels this should mean government bond prices continue to fall.
Christopher Jeffery, bond strategist at Legal and General Investment Management said the Japanese central bank has also reduced the quantity of bonds they are buying, which should serve to push yields higher.
In terms of where he is finding value, Mr Foster said: “High-yield bonds have benefited from equities' strong performance as well as from a very low level of defaults. We feel they have room to continue to outperform, but remain cautious about some sectors and stocks. We favour the US dollar market, which is less distorted by government intervention.”
Many investors, including Mr Foster, have been buying the bonds of banks, taking the view that higher bond yields will lead to more income for financial institutions.
But that view is predicated, as Mr Foster said, on the bond yield curve “steepening”, that is, the gap between the left side of the line and the right, becoming larger.
The left hand side of the line represents the interest rate on very short term assets, which is lower than on the right hand size, which represents the rate charged on longer term loans.
Banks make a profit by borrowing for the short term at low interest rates, but lending for the long term, so the wider the gap, the better for banks profitability.
But the curve has not become steeper. The line has straightened, meaning both long and short term borrowing costs have risen.
Rob James, financials analyst at Old Mutual Global Investors said that while a steeper curve is better, rates have been so low in recent years that any rise in long term rates will boost bank profits.
Shrenick Shah, who jointly runs the £958m JP Morgan Global Macro Opportunities fund, said economic indicators from around the world show only very limited signs of inflation picking up, so market moves to reprice assets that will do better when inflation rises may not be justified.
David.Thorpe@ft.com
