Bonds have had a bad run recently. Yields on US 10-year Treasuries are up by 35 bps since the lows in early April and the yield curve has shifted up in parallel so that prices for long-dated Treasuries have fallen heavily. This does not reflect a rise in inflation expectations – breakevens have been relatively stable. Real yields have risen.
If it’s been a tough time for investors in US government bonds, their UK equivalents have suffered even more. Gilts have underperformed. Holders of the 50-year UK indexed-linked Gilt have suffered a capital loss of close to 30% since early April.
In this week’s Perspectives I consider the prospects for bonds and the implications for other markets. But don’t worry, I not going to add to the mountain of words on the US debt ceiling as I don’t think it has anything to do with that. I put it down to three separate but related factors.
First and foremost is the move from quantitative easing (QE), where central banks buy up their Governments’ bonds, to quantitative tightening (QT), where they do the reverse. QE was executed on a massive scale when official interest rates – which are set on very short maturities – reached their effective lower bound. The switch from QE to QT was telegraphed by central banks well in advance and government yields rose in response. So why another leg up now? I suspect central banks may speed up the pace at which they run down the stock built up by QE.
I discussed in a recent Market Perspectives how the problems faced by US regional banks were exacerbated by QE. It’s all a bit technical but the need to pay interest on excess reserves has blocked an important safety valve in the US. I would not be surprised if this is discussed in one of the many speeches from Federal Reserve members due this week. They could and should speed up QT.
Second, fears of an imminent recession following the string of US bank failures have receded. The survey of Senior Bank Loan Officers published recently showed only a small further tightening. An influential survey of credit availability to small businesses showed a similar story.
There is no doubt that there is a credit squeeze going on – the natural counterpart of all those hikes in Fed funds. However, there does not seem to be a sudden sharp restriction of credit. In addition, signs that the US labour market was weakening, based on a steady rise in initial unemployment claims, were revealed to have been a mirage: there have been fraudulent claims in Massachusetts. Adjust for that, and the upward trend in initial unemployment claims disappears.
Third, traders in the futures markets with long positions in government bonds were forced to cut their positions – selling bonds – as yields rose. This type of reaction is always there but it was unusually large recently.
So much for the history. Where do we go to next? First, I think the recent rise in yields makes bonds attractive. Yes, QT means more supply but the price has already adjusted and demand will come back, switching out of other financial assets. Reduced demand for credit –also evident in those surveys I mentioned. In particular, that steep rise in UK indexed linked yields makes it very attractive for pension funds to lock in their funding. That raises the demand for Gilts. Conventional Gilts should see some further buying if, as seems likely, data this week show a big drop in UK inflation.
Second, while some US economic data have been stronger of late this has not been true across the board. Recession there has been postponed rather than cancelled in my opinion. Housing stabilised following the drop in mortgage rates from last October to early Feb but mortgage rates have since risen almost back to the previous peaks and a renewed downturn is likely to follow. In addition, evidence suggest that US corporates are cutting Capex: Goldman Sachs’ capex tracker has fallen into negative territory. Much of this reflects the squeeze on corporate margins. When they cut Capex, they tend to cut jobs too.
So, we expect Government bonds to rally. This would support equities but with corporates under pressure equites may do no more than tread water. I’ll discuss all this in more detail in my webinar on Wednesday. See your CTI rep if you would like to sign up.