In recent months bond bears have been reinvigorated, and market commentary suggesting “the end of the bond (bull) market is near” has become commonplace. We think these comments are premature.
Explaining the global government bond sell-off
October has seen renewed pressure on global government bonds, initially provoked by a Bloomberg article suggesting that the ECB was considering when to taper its quantitative easing programme; a story, by the way, that has now been fully refuted by Mario Draghi.
But there are other factors at play as well; overall, the global government bond sell-off appears to have been driven by:
- The idea that central banks are out of ammunition, or have lost their desire to continue with QE/NIRP/ZIRP
- A potential for a shift from monetary easing to fiscal easing
- Concerns about rising inflation, driven in particular by higher oil prices
As illustrated below, most global government bond yield curves have seen a notable bear steepening this month.
Why have gilts underperformed?
Gilts have been notable underperformers during the global government bond sell-off that began in October.
The catalyst was the Conservative Party conference that concluded on 5 October, where lingering market hopes of Brexit not actually happening were dashed by Theresa May, who put forward policies suggesting a “Hard Brexit”, the implication being that the UK would leave the single market. She also appeared to criticise the Bank of England's QE policies, suggesting a move away from monetary easing to fiscal easing. Reduced monetary stimulus and greater fiscal easing should cause higher yields and steeper yield curves, all else being equal.
The policy uncertainty that resulted from the conference helped cause a 6 per cent plunge against the US dollar and a 4 per cent drop against the currency of the UK's main trading partner, the euro. Sterling weakness pushed both inflation expectations and government bond yields higher.
The factors above have contributed to UK assets starting to exhibit a risk premium. This is illustrated below, where the correlation between US and UK interest rate differentials and the GBP/USD exchange rate has recently broken down.
The UK, then, is at the sweet spot for a number of factors driving higher yields and steeper yield curves:
- Higher inflation and inflation expectations
- A twist away from QE to fiscal easing
- Lack of confidence in UK Plc from abroad
Is the sell-off justified?
There is certainly some basis to the drivers, but investors need to be careful to differentiate between markets.
Inflation
Inflation is edging higher in the US, and there is potential for that to continue if the labour market continues to tighten. However, the US is an exception in the developed world: core inflation in the eurozone stands at just 0.8 per cent, while market-implied measures of future inflation remain extraordinarily depressed.
In the UK, headline inflation will inevitably rise after the fall in sterling. GBP effects on inflation appear with a lag, so we are yet to see the full pass-through, but recent headlines about UK inflation 'rocketing' higher are misleading: September headline inflation was only 1 per cent YoY, while core inflation is currently at 1.5 per cent. It seems unlikely that this will jump much above 2 per cent in the next few years.
Meanwhile, global deflationary dynamics are persisting, and policymakers are likely to look through the base effects caused by higher oil prices. Indeed, China's 8 per cent devaluation in the past 12 months on a trade-weighted basis means that China is exerting even greater deflationary pressure on the rest of the world than when Chinese producer prices were falling at a rate of 6 per cent YoY in 2015.
Is QE dead as a policy tool?
The aggressive bear steepening seen in most bond markets suggests markets are pricing in a reasonable prospect of QE ending soon. This began with the Bank of Japan, which was set to 'engineer' a steeper yield curve. Investors were then left disappointed as the curve flattened following the actual event. The BoJ's targeting of 10-year yield is certainly not the end of QE, and could in fact involve more purchases. It certainly acts as an anchor for global bond yields.
We also don't believe there will be any meaningful ECB tapering: eurozone inflation is very low, inflation expectations are anchored, growth is weak and unemployment is still high, which means we are unlikely to see inflation pressures. If they go ahead and do taper, we think it would be a policy error that would be reversed, and would represent an excellent buying opportunity.
Step forward fiscal policy?
Central bankers have been asking politicians to do their bit for some time, and it seems, in some cases, we may see this happening. Overall, this seems a sensible approach: QE has diminishing returns, other negative externalities (such as inequality) and would work better if supported by fiscal policy.
The key is to understand that the future policy mix could vary enormously by country. In the UK, for example, there seems to be political will to increase fiscal stimulus, and questions at least about the benefit of additional monetary stimulus. In Europe, however, fiscal caps and Germany's conservatism make any large fiscal expansion very unlikely, which is another key reason why we think the ECB will ultimately have to extend QE, and probably increase it. In Japan they have been doing huge monetary and fiscal easing for years, but with little to show for it. The lesson from Japan is that, if a country's demographics are rapidly deteriorating, in the long term it probably doesn't matter what the policy mix is since growth will probably weaken regardless. Lower growth means lower bond yields.
Our takeaway is simple: the domestic and global factors that have sent bond yields higher are already priced in; while we thought that government bond yields got too low in August and September, we think G10 fixed income remains attractive to own at current levels.
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