Recent days have seen significant volatility in global bond markets. Prices have fallen sharply and yields have risen, as investors digest the potential implications of a decisive shift in US economic policy under the future presidency of Donald Trump.
Tax cuts, infrastructure investment and more US manufacturing jobs
Concrete details of which policies a Trump-led administration may enact are thin on the ground. On the campaign trail Donald Trump advocated an agenda of significant tax cuts, the deregulation of financial services and a sizeable programme of infrastructure investment to boost domestic growth. Other campaign themes have included pledges to curtail immigration into the US and deport illegal migrants, the spectre of aggressively raising tariffs on Chinese and Mexican imports and measures to encourage the repatriation of manufacturing jobs to the US.
The combination of such policies at a time when US unemployment is already very low clearly signals a marked pick-up in inflation. It is this expectation, along with the prospect of a widening deficit to fund this programme, that the markets have been factoring into bond prices. If inflation rises, very low bond yields must rise to compensate for this.
Low yields are nothing new
The steepening of the bond yield curve is all the more dramatic given the prolonged low-yield environment that has been in place for some time. This is a direct result of Central banks across the globe cutting interest rates to record low levels in the wake of the global financial crisis, as well as implementing unconventional measures such as quantitative easing (QE) to try to stimulate the financial system. Deutsche Bank recently estimated that since the collapse of US investment bank Lehman Brothers eight years ago, Central banks across the globe have collectively cut interest rates a staggering 672 times.
Quantitative easing has become part of the problem
Alongside ultra-low interest rates, QE programmes have involved Central banks electronically creating new money and using this to buy bonds and other financial assets. This adds liquidity to the financial system while keeping bond yields – and therefore borrowing costs – very low in the belief that this will encourage economic activity. Scepticism towards QE has however been gathering momentum, including growing criticism from politicians (not least Mrs. May).
In economic terms, critics of QE argue that this medicine – which was originally introduced to help alleviate the financial crisis – has now become part of the problem. Easy credit has resulted in a misallocation of capital into the financial markets rather than the real economy. This has propped up weak businesses, leading to excess capacity of goods and services, and therefore weak growth.
Central banks have fuelled wealth inequality
Another impact of very low yields created by such policies has been to fuel wealth inequality. Central bank financial alchemy has boosted stock and bond prices, making asset owners wealthier, at a time when wage growth across the developed world has been sluggish.
The resentment that this has fuelled, and a sense that the 'recovery' since the financial crisis has benefitted the few rather than the many, is widely seen as a powerful driving force behind the rise of anti-establishment political movements which have delivered two major political shocks this year – the UK’s vote to leave the EU and Donald Trump’s US presidential victory.
Is the bond bubble about to burst?
For some time now, there have been lurking concerns of a bubble building in bond prices that could eventually burst as Central banks begin to “normalise” monetary policy by raising interest rates. But expectations of such increases have repeatedly been kicked into the long grass.
While the markets have been placing a high probability of a US interest rate rise being announced in December, the real question is the speed of further rises over the coming year. Given the uncertainty around the policies the incoming US administration will actually adopt, over those campaign commitments that might be dropped or watered down, there is the potential for big swings in expectations that could lead to ongoing volatility in bond markets.
We remain cautious over bonds
In the portfolios we manage for clients, our investment office has been cautiously positioned towards the bond markets for some time. This has been due to our expectation of increased volatility and doubts about the sustainability of ultra-low yields.
If bond yields do eventually stabilise at higher levels than we have seen for several years, this will help rehabilitate the asset class as an attractive option for income seekers. But for now we believe it is right to remain cautious, given the uncertainties around the changing direction of US economic policy, a growing appetite for fiscal stimulus across the globe and the outlook for inflation.
For more information about our investment views please get in touch on firstname.lastname@example.org or 020 7189 2400.
Bonds issued by major governments and companies will be more stable than those issued by emerging markets or smaller corporate issuers; in the event of an issuer experiencing financial difficulty, there may be a risk to some or all of the capital invested. Please note that historical or current yields should not be considered reliable indicators of future performance.