Bond market players sanguine amid warning signs

London

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

Historically, rising inflation, higher economic growth and government borrowing, and an increase in US Federal Reserve Bank interest rate rises would be negative for the bond market. In the past six months, bond yields have begun to rise, but the increase has been small, so government and other bond prices have fallen by negligible amounts.

Following declining interest rates and a surge in issuance, the global bond market grew from US$69.4 trillion in 2009 to US$92 trillion in 2016, according to data from the Bank for International Settlements. This compared with US$70 trillion for global equities. US treasuries, corporate and other bonds account for an estimated US$39 trillion, or 42 per cent of the global total, compared with the European Union with US$24.6 trillion, Japan US$12 trillion and Singapore US$326 billion. Thus interest rate trends in the US are the key to global bond market forecasts, unless there is an unusual event elsewhere.

The most telling statistic comes from Merrill Lynch which shows that volatility - US treasury bond price fluctuations - are at the lowest levels in five decades. This indicates that the market believes that the bond market will cope with central bank rate rises; that the "Goldilocks" era of minimal bond price movements and relatively bullish equity market conditions will continue. The majority of fund manager and investment bank forecasters are following the Fed's predictions 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. For this reason and because economies and profits are growing, the majority are continuing 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, Australian and Singapore 10-year bond yields are only slightly positive while 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 for any change in interest rates. 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. Moreover if inflation spikes and rises to levels that are much higher than expectations, yields could rise further and losses on 10-year or even longer term bonds could exceed 10 per cent.

A sudden surge in oil prices, for example could push up inflation. This is possible as current Iranian protests against the regime, which are currently taking place in eighty cities, could become a full scale revolt and raise worries about the nation's oil production.

Colin Martin, fixed income strategist of Schwab, sums up the majority view, notably 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, who has his own consulting firm, and Lacy of Hoisington, a specialist in US Treasury bonds, believe that the US economy and profit growth are peaking. These two economists, who have been among the most accurate bond forecasters in the past three decades, predict that bond yields will decline again. Any global stock market tumble could encourage investors to flee to quality bonds as an insurance, they believe.

Mr Martin says that as it is difficult to time both bond and equity markets, and suggests bonds with a short to medium duration, that is, seven to 10 years. Such a strategy would limit risks, he maintains.