The dramatic moves in government bond markets since the start of the year are changing the landscape for wider financial markets.
- In early May, the US 10-year treasury yield ticked over 3% for only the second time this decade
- Over the past decade, negative yields have helped support equity markets
- Rising bond yields leave investors with less incentive to take risk, which may exert a drag on risk assets generally.
Fixed income markets are on track for their worst start to the year since records began in the 1970s. The US 10-year treasury yield ticked over 3% for only the second time this decade, while the UK 10-year gilt hit levels not seen since 2014. This weakness raises some interesting dilemmas for investors.
For most of the past 10 years, equity markets have been supported by the reassuring knowledge that bond yields were too low to appeal to anyone but the most bearish. This was the ‘TINA’ trade – ‘There Is No Alternative’. Investors were pushed into stock markets and other risk assets to have any hope of beating inflation.
Tentatively, fixed income has started to offer a viable alternative to stock market investment. Bond yields have moved very quickly in response to rising rates across developed markets. Admittedly, with inflation at 7% and bond yields at 2-3%, they are still limitations to fixed income markets, but inflation should start to roll over in the second half of 2022 and those yields may seem more attractive.
Equally, fixed income may have more appeal as investors contemplate recession in the US or Eurozone. This is not as remote a possibility as it seemed just a couple of months again. Keith Wade, Schroders chief economist, recently said that the hoped-for soft landing for the US economy now looked unlikely and that “a recession may be a necessary trade off for lower inflation.” He believes inflation is becoming entrenched and monetary policy is an unpredictable tool to deal with it.
In this scenario, it is plausible that markets experience a reversal of the bond proxy trade that prevailed in the wake of the Global Financial Crisis. In this case, steady growth companies with predictable but unexciting dividends could be vulnerable. It also raises the bar for investment generally. Investors no longer have the same incentives to take risk, which may exert a drag on risk assets generally.
Equity investment is unlikely to be the no-brainer it has been over the past decade and investors may need to be more nuanced in their asset allocation. For so long, government bonds have offered huge downside risk, with minimal update. Today, those risks look more finely balanced. The investment landscape has meaningfully changed over the first few months of 2022.