After a 30-year bull market, fixed income investors are now staring down the barrel: 2017 could be the year the government bond bubble finally bursts. It's no time to be blithely banking on bonds.
The end of an era
And yet it remains quiet, possibly too quiet, in the bond markets. Although higher, current US Treasury yields - as at 16 March they were around 2.52% - imply people are still expecting the kind of monetary policies that have suppressed yields since the Global Financial Crisis to persist. They also suggest President Trump's economic measures will fail. Neither looks likely.
In fact, macroeconomic indicators are pointing to improving activity. We expect the US economy to grow by around 2.5% this year, slightly above consensus estimates. A slight caveat - there are some bearish signals too.
What does this mean for yields? We (Lyxor Cross Asset Research) believe there's a 50% chance that 10-year US yields will reach 3% by the end of 2017. But we also see a 40% chance of yields surpassing 4%. Should the economy struggle unexpectedly they could plunge to around 1.5%. But we believe there's only a 10% chance of this happening.
Big implications
US yields have big implications for European investors as US Treasuries and G9 government bond yields tend to move in tandem when bonds are falling. And this was indeed what happened in Europe after the US election. In our view, market participants who assumed the sell-off was overdone are yet to adjust to the new reality.
Policies are changing almost daily in the US, so further sell-offs can't be ruled out. The Fed has however learned its lessons. The recent 0.25% hike was signalled loud and clear, so its impacts on the markets were limited. And, by sticking to its expected normalisation path - five more hikes between now and the end of 2018 - the Fed clearly intends to stay "behind the curve" to help growth momentum build up.
Whether it can even join those dots in a world so leveraged to the dollar, and so sensitive to US borrowing costs, remains to be seen.
Europe in the firing line
With valuations seemingly rich, eurozone bonds are firmly in the firing line and looking more precarious. An ECB taper in September would, in our view, be a mistake. Much depends on whether Draghi and his doves can resist the temptation. Political risk has also helped keep a lid on yields, but forthcoming elections in France could change that.
Brexit battles
A "hard" Brexit looks likely, as does considerable political uncertainty. A rapid exit is possible should the cost of a negotiated settlement become so high UK negotiators conclude it's cheaper to walk away. This would lead to further falls in sterling and gilt prices.
There is an opportunity to make common cause with other member states for a bespoke deal that maintains good access between the UK and the EU. Even so, sterling remains depressed, which will eventually feed through to higher consumer prices. Inflation pressures should keep rising from here.
While we expect inflation to end the quarter above the Bank of England's 2% target, the chance of a near-term rate change looks limited. Growth could slow in 2018 and, with Brexit scheduled for early 2019, a rate rise looks unlikely. That said, with no more easing in sight and the latest tranche of quantitative easing nearing an end, the outlook for conventional UK gilts is neutral at best.
Know your credit limits
After a good 2016 for credit, it's difficult to be too optimistic this year. Spreads should widen as general bond yields rise. In fact, if they properly reflected political risk, they'd already be much wider than they are now. The coming months could be difficult but healthy corporate fundamentals, a low default rate and a more robust banking sector provide some support.
After the party
So what should investors do in case the peace in the bond markets is shattered? Tactical trading may be important with bouts of volatility rocking today's relatively illiquid fixed income universe. Hedging with linkers, breakevens and floating-rate notes could also help. Look to short-dated or high-yield bonds to reduce rate sensitivity, and use shorts to protect against, or exploit, downturns.
Disclaimers:
All data: Lyxor Cross Asset Research & SG Research, March 2017. Opinions expressed are as at March 2017.
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