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Towards the end of January, UBS he asked the most important question for global markets: “Bond bones come out of hibernation, but is it too soon?”
Hibernation was possibly not the right word. Strong demand and falling benchmark interest rates meant that U.S. government bond yields, the center of the market universe, had been sliding fairly smoothly for nearly 40 years. Therefore, less a case of waking up from a winter sleep, more a case of the resurrected undead.
In any case, six months later, it seems that investors decided it was too early. The big downside of 2021 was striking: the yield on 10-year U.S. government bonds reached 1.77% in late March and the first quarter was the darkest for the market in four decades. But this week it has rethought sharply, leaving yields as low as 1.25 percent, still well above the starting point of the year, but with a severe sting.
It is worth reliving some of the origins and key moments of the bond clash.
Their security and stability make government bonds love misery (among other things). So when news of the vaccine launch late last year hung the tempting prospect of a return to normal post-pandemic life for the first time, that dragged them down.
The real blow came, however, from the spectrum of inflation, the real kryptonite on the market, as it consumes the fixed rate of return on bonds. The Democratic Party’s success in gaining control of the U.S. Senate with a victory in early January in Georgia sparked expectations of an overburdened tax spending. Powerful accepted wisdom was developed, with persistent growth, lasting fiscal support, and a Federal Reserve that would turn a blind eye to rising price pressure.
“The January narrative was a cake in the sky, it was rainbow and fairy dust,” said James Athey, investment manager at abrdn, the asset manager that inexplicably changed its name this week from Aberdeen Standard Investments. (For anyone wondering, “Aberdeen” is pronounced. I don’t understand either.)
In this environment, a trembling seven-year U.S. government debt auction in February (usually a more humble event that would captivate only purists) ended up causing a sharp drop. Ten-year yields ended the day about 0.14 percentage points higher, a big move by typically quiet U.S. market standards.
He recalled that while U.S. government bonds are the basis of global markets, which support the price of virtually every riskier asset class in the world, they have their moments of instability under pressure. This is a fault line that can be tested when the Fed pulls its breadth further.
Even Steven Major, head of bond research at HSBC and one of the most well-known and bullish voices on the street, dit in February he “ate humble cake.” At the time, Major increased its year-end forecast on ten-year yields by a quarter of a percentage point.
Now, however, as Athey points out, investors are lowering some of the more generous expectations around tax spending. Inflation has risen sharply, but investors are increasingly confident that much of it seems to be rooted in the inevitable bottlenecks in a rapidly emerging economy from the blockades. And, crucially, the Fed has reinforced the message that its slightly more relaxed stance on rising prices in the post-crisis recovery does not mean it has completely abandoned its inflation target. Tariff adjusters have indicated that the reduction in policy rates may come a little earlier than previously anticipated.
The result is a 0.19 percentage point drop in 10-year yields to last week’s low point, albeit with a small rebound on Friday.
A mystery here is precisely what caused the rush to the links. Some of the alleged underlying reasons have been going around for a few weeks with a much more limited effect.
Perhaps the most popular explanation is positioning: investor consensus had become so strong and the trade of reflation too popular. When this positioning began to unravel, the resulting recovery in bond prices caused investors who were still short. These types of compressions can self-reinforce quickly.
Major, which meets its 1 percent to 10-year profitability target by the end of the year, is unconvinced on this front. “Positioning is an ex post rationalization,” he said. “It’s a bit of an intellectual failure.”
But he suggests investors should rethink the real engines of government bond demand, even at times of huge issues. “You can change them in cash without even moving the price. It’s real liquidity, ”he said.“ Can you do this with your home? Can it be done with cryptography? “
What happens next? Naturally, it takes two parts to make a market. UBS Wealth Management said this week that it still expects returns to reach 2% this year, while the BlackRock Investment Institute is also fleeing from government bonds on the basis that thin yields offer little amortization to offset shocks elsewhere in the portfolio.
Major, too, believes the recovery in bond prices is largely over by now. But he adds: “We’re not going short and we haven’t changed our forecasts. We still have half a year to go.”
katie.martin@ft.com
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