At the start of this week, we witnessed a strange turn of events in global government bonds: the 10-year German government bond yield turned positive! What is going on? Aren’t we supposed to pay governments for the privilege of lending them money?
10-year government bond yields are approximately 20bps to 35bps higher in the US, Japan and Germany since they troughed around two months ago. Are we seeing the beginnings of a bear market in government bonds? No. We believe this is a short term correction and not the start of a long term upward move in yields. The structural decline in bond yields globally is by no means over.
Reasons for the correction:
Government bond yields declined until mid-summer because of weak H1 growth in the US and tentative signs of labour market weakening (which have since improved). In addition, bonds were bought to protect portfolios both before and after the Brexit referendum. There were also expectations that both the ECB and BOJ would have announced significant new easing measures by now.
The immediate reality of the UK’s vote for Brexit has not been as bad as many had predicted. Whilst PMIs plunged in July, the decline was reversed entirely in August. Eurozone data also remained largely unaffected by the uncertainty triggered by the vote.
Globally, it is not just the Brexit panic that has so far not materialized. Despite continuing long term structural issues, China has not been a cause of concern over the last quarter whilst EM growth has picked up. In the US, we expect H2’s just above trend growth to be the mirror image of H1’s just below trend growth.
It therefore makes sense for some profit taking in government bonds. The Fed has signalled that data permitting, they may raise rates again by the end of this year. Indeed we expect one hike in December and one hike next year, an extraordinarily slow pace of one hike per year.
Last but not least, longer maturities bond yields have been rising because of the Bank of Japan. The BoJ indicated that the significant yield curve flattening that followed their previous policy measures are becoming burdensome on long term investors who need higher yields to match their liabilities. The costs of easy monetary policy are therefore increasingly offsetting the benefits. Hence the market now expects the BoJ to announce policy measures designed to steepen the yield curve (the reverse of the Fed’s Operation Twist is one way we like to characterize this). The BoJ does not want higher overall bond yields, but they do want lower yields at the front end and higher yields at the back end. Banks and non-financial corporates usually borrow at the short end, and so lower short end yields and higher long end yields may be helpful to both short and long end investors. It remains a policy implementation challenge to see if the BoJ can indeed engineer such a “reverse Twist”.
We are long term investors and notwithstanding the correction that we are currently witnessing, which we do not believe has far to go, the predominant long term trend for bond yields is still downward. The reasons have been examined in previous blog articles: low growth, low inflation, global slack and global imbalances (for example in commodities and in parts of EM) that continue to linger but which are not yet at tipping points. Central banks are still in the driver’s seat and they will continue to drive overall bond yields lower.