What does the future hold for a nervous bond market?

That presents bond fund managers, and asset allocators, with a dilemma, as bonds were considered expensive pre-pandemic, and now have reverted to that level despite the radical uncertainty of the world around us. 

If the actions of Volcker started the bond bull market in the early 1980s, it was the words of Lawrence Summers, a former chief economist at the World Bank, who described the conditions prevalent in the global economy after the financial crisis as being “secular stagnation”, which guided many investors thoughts since then. 

The features of secular stagnation include high debt levels and ageing populations in the developed world combined with high savings rates and lower wages in the emerging world, creating a scenario where growth and inflation remain perennially low, the ideal conditions for bond investors. 

In such a world, bond prices would not fall much in normal times, but would still rise in times of extreme market stress, as they did in the spring of 2020.  

Many policy makers tried to counter this by cutting interest rates even further, a practice economist John Maynard Keynes compared to pulling on a string.

We continue to hold conventional bonds in our client portfolios. They continue to dampen the inevitable volatility you expect from equities as they act as a shock absorber in bad times – it's still true that when equities go down, bonds tend to go up.--John Butters

New order   

Milburn says the bond market is “horrendously overvalued” right now, partly as a result of central banks spending trillions of dollars buying them, but that what might be happening now is investors are wary of the secular stagnation trend coming to an end. 

This could happen, says George Lagarias, chief economist at Mazars, because the savings rate in the global economy is now “too high” and as people start to spend that pushes demand, and potentially inflation, higher.

The second variable is that, unlike in the immediate aftermath of the global financial crisis, governments are materially increasing spending alongside the low interest rates, so there is no longer just Keynes' piece of string to pull on, but also government money attempting to jolt economies out of recession. 

Milburn adds that central bankers have communicated to the market they are much more willing to allow inflation to rise now than was the case in the past, and higher inflation is bad for bonds. 

Lagarias does not believe inflation will be a longer-term feature, as he feels that after an initial bout of spending and stimulus, consumers and companies will become more cautious as they observe the high debt levels in the economy.