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As the end of the first quarter approaches, many bond investors are looking back on a sea of red on their screens or gloomy reports from their fund managers. The backdrop is clear: an expensive asset class came under pressure from an evaluation of future prospects. It may be the case that central banks in the major economies have kept interest rates on hold, and promise to do so for years to come, but the outlook for growth and inflation is very different from even a few months ago. As a result, the benchmark 10 year US government bond yield rose from about 1.0% to about 1.75% during the first quarter.

Nevertheless two interesting trends are worth examining within this tale of gloom. The first is the divergence between the market’s performance in March versus the other two months. The second is the divergence in policy decisions being seen between countries. Together these explain the relative performance which is appearing. The two worst performing markets have been the UK and USA, with price declines of over 5%. Indeed, the UK is on track for the worst performance on record stretching back to 2000, according to a Bloomberg Barclays index. In contrast the price declines seen in Europe have been closer to 3%.

Prospects for economic growth in the USA and UK are clearly improving. Spurred on by an upgrade to Federal Reserve forecasts, mainstream economists are looking for US GDP to expand 6-7% this year. At the same time, the OECD has upgraded the UK towards 4%. In contrast, European GDP estimates for 2021 are being lowered, again towards 4%.

Part of the explanation relates to the relative success vaccination programmes in the USA and UK versus Europe. Much of the Continent is experiencing another lockdown as health systems come under pressure. Just as importantly, and probably more significantly in the case of the United States, is the relative degree of fiscal stimulus which is being seen. Almost as soon as President Biden was able to push the stimulus package worth $1.9 trillion through Congress, he has opened negotiations on a further $3 trillion package of infrastructure and climate spending. “Spend today, tax tomorrow“ seems to be his mantra, undoubtedly driven by the political dynamics. In the UK, the Chancellor indicated in his Budget statement at least 1 to 2 years of easy fiscal policy before he needs to take harsher decisions on taxes or spending. In contrast, Brussels bureaucracy seems to be leading to a slow release of the rescue funds agreed last year, leading Spain for example to reduce its official GDP forecasts for 2021

Although January and February were difficult months for bond investors, it is noticeable that March has seen relative stability. UK 10-year gilt yields have fluctuated in a range of 0.7-0.85% for example. Perhaps the calm before the storm? Whenever markets become extended, a modicum of “good“ news can cause a re-assessment. The inflation backdrop has certainly been helpful in March. Most of the current figures have been reasonable, as demonstrated by headline inflation in the UK decelerating to only 0.4% year on year, on the back of a further slide in clothing and second-hand car prices. Oil prices are another issue. The direction of the bond market often correlates with movements in oil prices, partly as the cost of energy quickly feeds through into headline inflation whilst also having a bearing on future inflation expectations. The recent fall in the oil price from $70 per barrel towards $60 appears to relate to the news of further lockdowns in Europe alongside the tightening of monetary policy in China.

Where next for the bond market in the second quarter? The mix of positive and negative drivers is unlikely to change much: the next stage of the pandemic, central bank decisions, whether supply chains can cope with the recovery in consumer demand and business investment, or the extent of the much anticipated rise in headline inflation. It would not be a surprise if markets tested 2% on US and 1% on UK benchmark yields. However, in a world of close to zero interest rates, many investors are expected to step in periodically to take advantage of higher yields. Just as seen in the first quarter, markets often operate in a step by step or ratcheting process.

Andrew Milligan is an independent economist and investment consultant. This note should be considered as general commentary on economic and financial ma;ers and should not be considered as financial advice in any form.

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