The economy is rolling and it’s all bad news for the bond markets, right? But is there an alternative view?
- Inflationary pressures are mounting, interest rates are rising – the assumption is that bond yields must rise from here
- Certainly, the economic environment has changed from one of ‘QE’ to one of QT’
- However, longer-term, asset markets are nervous about recession.
At the moment, there is pretty much one narrative about the bond market and one narrative only. Inflationary pressures are mounting, interest rates are rising, bond yields are rising and you’re better off out of most fixed income asset classes.
That seems to be reflected in recent moves in 10 year government bond yield. The US treasury, for example, has climbed from lows of just over 2% in September 2017, to its current level of almost 2.9%. The moves in the UK are similarly extreme – rising from below 1% in September to 1.6% today.
There can be little doubt that the environment has changed. Central banks are rolling back on quantitative easing. For much of last year, the bond market didn’t believe the Federal Reserve, but recent metrics – such as wage growth - have forced it to take the US central bank at its word and adjust accordingly. And where the US leads, other bond markets follow.
The question now is whether bond markets will now slowly deflate, or whether the slow down has largely run its course. Certainly many investors appear undeterred by the recent events. The strategic bond sector has been the best-selling UK sector four times in the past six months.
The bond markets themselves also appear to believe that the current bout of inflation will be temporary. The yield curve has flattened as investors have become concerned that tighter policy will ultimately choke off growth and inflation. David Roberts, head of global fixed income at Liontrust recently reminded investors that this tends to be an “end of cycle” phenomenon – the ‘last hurrah of economic expansion’.
However, while this has usually been a reasonably good predictor of the next recession, it takes time between the inversion of the yield curve and the economy turning down. Roberts says it can be as long as 15 months and equity markets may not yet have hit their peak.
How can there be a recession following the vast fiscal stimulus seen in the US? Fiscal stimulus fades, the bears argue, and tends to be arbitraged away by central banks. Its effects are temporary and ultimately damaging.
In this way, perhaps bond and equity markets understand what economists do not – there is a recession coming. Perhaps not immediately, but investors may not get a lot of warning when it does.
