Bond market players sanguine amid warning signs

Market ignores inflation and believes “Goldilocks” era of firm bond and equity prices will continue.

GLOBAL market participants are sanguine about bond and equity markets, despite economic and financial warning signs.

In the past, rising inflation, stronger economies, large scale government borrowing, and US Fed’s rate rises would  dent bond prices.  Instead bond yields have only risen slightly and bond prices have hardly fallen.

The global bond market has grown from $69.4 trillion in 2009 to $92 trillion in 2016, according to the Bank for International Settlements (BIS).  The size of the global equities market was $70 trillion.

US treasuries, corporate and other bonds account for an estimated $39 trillion, or 42 per cent of the global total. The European Union  share is $24.6 trillion and Japan $12 trillion.  US interest rate trends are thus the key to global bond prices, unless an unusual event occurs.

The most telling statistic comes from Merrill Lynch. The firm shows that volatility – US treasury bond price fluctuations – is the lowest in five decades. This indicates that investors  believes that the market will cope with central bank rate rises. They expect the “Goldilocks” era of minimal bond price movements and rising equities to continue. The majority of fund manager and investment bank forecasters are following the Fed. They believe that it will raise interest rates further this year. They expect bond yields to rise slightly and the setback in bond prices to be small. Since economies and profits have been growing, the financial crowd continues to tip equities.

The trough in bond yields and hence the peak of 10-year government bond prices took place in 2016. Since then US treasury bond yields have risen from 1.39 per cent to 2.48 per cent and 10-year German bond yields from minus 0.17 per cent (negative yield) to positive 0.43 per cent. Other nations have followed. But inflation is turning upwards and real, inflation-adjusted US, Canadian and Australian 10-year bond yields are only slightly positive . In contrast German, Japanese and UK real yields are negative.

This illustrates that the bond market has become risky. The longer the duration of the bond, the greater the price fluctuation. If yields rise to around 3 per cent, for example, 10-year bond prices would decline by around 5 per cent and wipe out the annual income. But if inflation spikes and rises to levels that are much higher than expectations, yields could rise further. Losses on 10-year or even longer term bonds would then exceed 10 per cent.

A sudden surge in oil prices, for example could push up inflation. This is possible. Iranian protests against the regime in some eighty cities, could become a full scale revolt. The energy market would obviously become worried about the nation’s oil production.

Colin Martin, fixed income strategist of Schwab, sums up the majority view. He predicts that 10-year bond yields will climb to a range of 2.75 per cent to 3.25 per cent. Economists such as Gary Shilling and Lacy Hunt of Hoisington, a s US Treasury bond specialist are more bullish. The two economists, who have been among the most accurate bond forecasters, contend that the US economy and profit growth are peaking.  They forecast that bond yields continue to be in a downward trend . Moreover, any global stock market tumble could encourage investors to buy quality bonds.

Mr Martin says that as it is difficult to time both bond and equity markets. He suggests that bonds with a short to medium duration, are safer e.g. 5 to 7 years

What is your view on inflation and global bonds?  Comments are below.

(This article was first published in The Business Times, Singapore.)

Jack of Diamonds Neil’s thriller on global diamond mining and smuggling, will be published in coming weeks. It is the sequel to the thriller, Trader Jack, The Story of Jack Miner. Book reviews are on neilbehrmann.net and Amazon and more reviews are welcome. Neil is also author of anti-war children’s novel Butterfly Battle- The Story of the Great Insect War. The updated 2015 Waterloo commemoration version of Butterfly Battle is on Kindle and e-books. If the paperbacks are purchased direct on this site, a proportion of the proceeds will go to low cost charities.)

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