MUNIX COMMENTARY – July 8th
The wisdom of the bond market
What does the bond market know that the rest of the world does not? There is a well-known story about James Carville, a US political adviser, who quipped “I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody.”
The UK benchmark gilt has been range-trading between 0.7-0.9% yields for most of this year. This range has broken, with the latest reading closer to 0.55%. It is difficult to point towards major changes in how investors are seeing the state of the UK economy, more relevant appears to be developments in global bond markets. German 10-year yields have similarly fallen, as low as minus 0.3%, Chinese yields are down to 3%, while the key US 10-year yields have collapsed as low as 1.3%. Real or inflation adjusted US bond yields are close to the levels seen in the gloom of last summer when the pandemic was at its height, while the 2-year yield is trading back below the Fed Funds interest rate.
Why has this occurred?
The most obvious explanation is the realisation that the world economy cannot get any better, and indeed growth is starting to slow. While the IMF is forecasting that the US economy will expand 7% this year, a number not seen since Ronald Reagan was President, both in the USA and most countries the latest business surveys suggest that activity levels are starting to fall back, albeit far from dramatically. Looking at key sectors, automobile and white goods production will suffer from chip shortages for some time to come, housing markets are rolling over as unaffordability worsens, tourism is being affected by a myriad of rules and regulations surrounding vaccinations, and generally many service sector businesses report a shortage of suitable labour. All this is supported by renewed concerns about the impact of the Delta variant of the virus. Indeed, there is growing evidence that the world is facing a worsening two-track recovery, between stronger developed and weaker emerging market economies. driven by dramatic differences in vaccine availability, infection rates, and the ability to provide policy support. The Bank for International Settlements has warned that the worst is yet to come for such developing nations.
Bond yields are made up of growth and inflation expectations. Although some surveys are giving warning signs about a poor inflation outlook, generally based on higher oil prices, it is noticeable that labour markets still remain well behaved. The most recent payroll reports in the USA and Europe continued to show a steady recovery in hiring but few signs of a spark in wages growth. At the same time, most commodity prices have started to roll over due to Chinese intervention. Recent news that China is considering easing monetary policy to support small and mid-sized companies, suggesting a period of moderate activity in that economy, would further dampen inflation expectations.
Other bond market commentators would point less to the real economy data and more to signs that central banks are still loath to withdraw the liquidity which has propped up markets. Although some of the smaller players have taken small steps – examples include a recent decline in the Bank of Japan’s balance sheet, whilst the Reserve Bank of Australia has announced that it would start tapering in September, plus interest rate hikes in Brazil, Mexico and Russia – the USA is not close to acting. The latest set of minutes of the Federal Reserve’s deliberations made it clear that tapering will be discussed, due to concerns about the impact of over-easy policies on the state of the housing market, asset prices or inflation expectations. However, it still seems to be September or even December before a decision is taken.
Another possibility relates to politics. There is continual talk about the USA launching an infrastructure programme of $1-3 trillion but in reality it is mired in Congressional politics. Pressure seems to be growing for a smaller package, while looking ahead to the 2022 mid-term elections political analysts suggest that the Republicans will at least regain control of the House
of Representatives, limiting President Biden’s room for manoeuvre. If the fiscal stimulus looks to be smaller, then the US central bank may need to keep policy looser for longer.
Last, but certainly not least, there are complicated technical explanations for the latest bond market moves. Some are related to decisions by pension funds on re-balancing bond and equity positions in their portfolios at the end of the second quarter, after another period of strong share price movements. More important may be detailed changes taking place in the US Treasury’s account at the New York Federal Reserve. This ballooned to $1 trillion last year as part of the government’s efforts to support the economy. As it is being run down, in effect reducing the supply of bonds, while the Fed continues to make purchases through its QE programme, so the net effect is higher bond prices and lower yields.
The world’s largest bond markets are a highly complex mechanism for analysing interlinked developments in the major economies. A mixture of domestic and overseas news has brought about a major change in direction in US bond yields, rippling through into other fixed income markets and other asset prices. Technical analysis would suggest that the next major support for US yields might be about 1.2%. The next important aspect will be to see how the US central bank responds and whether it tries to give a steer towards the markets.
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Andrew Milligan is an independent economist and investment consultant. This note should be considered 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