Red for Stop, Amber for Caution, Green for Go
Bond investors have not enjoyed the past month. The global benchmark, the US 10 year bond yield, is on track for its worst month’s performance since November 2016, indeed the worst quarter since 1980, with the international plunge in bond prices sending yields well above pre-pandemic levels. Should investors buy or sell, is all the bad news in the price? Sadly there are green, amber and red flashing lights on the dashboard facing investors.
Markets anticipate a major policy tightening cycle with major central banks seeking to tame inflation, currently running at records levels in Europe and 40-year highs in the US. An open economy such as the UK means that its gilt market is affected by global influences, notably the surge in commodity prices, trade with key partners or international capital flows. The UK looks to be materially affected by developments in our European neighbours. Inflation is surging across the EU – German inflation rose above 7% a year in March while economists at ING warned there was a good chance that inflation rates will enter double-digit territory in the summer. The ECB will want to dampen such expectations, with further interest rate increases priced in for the coming year. German two-year bunds are on the verge of turning positive for the first time since 2014. The good news for policy makers is that as European yields return to positive territory so demand for corporate and government debt is re-appearing.
Nevertheless, the Bank of England is still not expected to take an overly aggressive stance. The political fall-out from the Chancellor’s Spring Statement is matched by the gloomy economic analysis. Earlier this week, Governor Andrew Bailey warned that household incomes adjusted for inflation are set to be hammered by an economic shock bigger than in any single year since the 1970s oil crisis. Discretionary consumer spending should slide as taxes rise and energy bills surge, in April and probably again in October. On top of this, businesses will suffer from weakness amongst European trading partners. The German council of economic advisers slashed its 2022 growth forecast for Germany from 4.6% to 1.8%. A jump in uncertainty as large as seen from the Ukraine war typically has a dampening effect on activity for 12-18 months. All this helps explain why UK money markets are pricing in a steady rise in interest rates in 2022-23, taking base rates to 2.0-2.25%, but considering actual rate cuts late in 2023 or into 2024.
The US bond market is beginning to flash amber warning lights. The gap between 2 and 10 year yields has narrowed to under 10 basis points. Indeed, earlier this week 2 year yields briefly climbed a fraction above 10 year, inverting that part of the curve for the first time since August 2019. Hawkish observers warn that this is the sign for recession appearing in the coming year. If that is the case, then valuations might suggest a buying opportunity for bond investors is approaching. Conversely, Fed Chair Powell has argued that the yield curve from 3 month interest rates to 2 years bond yields is the most reliable recession indicator – and that is still flashing green rather than amber. In any case, the amount of government intervention in bond markets over the last decade possibly dulls the value of this signal. Putting aside such debate, the bond market does appear to be signalling stagflationary pressures appearing in the US economy. The US mortgage rate is approaching 5%, causing the important housing market to start to roll over.
Lastly, the war in Ukraine should not be forgotten. The next big test will come on April 4th, when a $2 billion Russian bond, held both by domestic and International Investors, comes due for repayment. Does it have the money or does a debt default begin? Investors are also paying careful attention to negotiations between Russia and the EU about whether gas exports should be paid for in roubles or euros. European companies are already preparing for disruptions to gas supplies and low.
All in all it inflation reports are flashing red, longer-dated bond valuations are flashing green, but economic data and policy statements are flashing amber. Against such a complex background it is understandable that some analysts worry that central banks are making a policy error by being too lenient, or conversely that they will overtighten to put the inflation genie back in the bottle, or that investors are just too optimistic on likely economic outcomes. The dashboard needs careful analysis.
Bond yields at the time of writing this week and one month change
% 2 year 5 year 10 year
USA 2.28 (+0.75) 2.39 (+0.65) 2.31 (+0.46)
UK 1.35 (+0.23) 1.40 (+0.33 1.62 (+0.31)
Germany -0.02 (+0.59) 0.44 (+0.69) 0.61 (+0.57)
Andrew Milligan is an independent economist and investment consultant. This note is offered as general commentary on economic and financial matters and should not be considered as financial advice in any form.
Andrew Milligan an independent economist and investment consultant. From 2000-2020 he was the head of global strategy at Standard Life/Aberdeen Standard Investments, analyzing the major financial markets for global clients. He currently assists a range of organizations with reviews of their investment processes, advice on tactical investing and strategic asset allocation, and how to include ESG factors into their decision making