Fixed income markets have been surprisingly strong over recent months but bond investors should start thinking about how to protect their portfolios towards the end of the year.
That’s the view of Paul Brain, the investment leader of Newton’s fixed income team and co-manager of the £2.3bn BNY Mellon Global Dynamic Bond fund, who is warning investors not to become complacent because of “strange” recent events in bond markets.
One of the major market concerns at the moment is inflation and the risk that the massive amounts of pandemic stimulus combined with the global re-opening could cause it to spiral out of control. However, the bond market has not reacted to this risk in the way that many would have expected.
“Inflation has always been a serious influencer upon bond-market behaviour. The multi-decade decline in inflation since the 1970s explains in large part why we have enjoyed a multi-decade bull market for bonds,” he said.
“The reasons are simple: higher inflation erodes the fixed return you receive from a bond and prompts central banks to raise rates. It is therefore strange that, despite recent higher inflation, bond yields have fallen (returns have risen) over the last couple of months.”
Performance of US treasuries over 2 months
Source: FE Analytics
Despite higher-than-expected inflation (US CPI recently hit 5.4%) and central banks talking about tapering quantitative easing, the yield on the US 10-year government bond currently sits around 1.18%. This is down from 1.74% at the end of March.
Brain suggested several supply/demand reasons why this could be the case, including the US Federal Reserve buying up all the net supply of treasuries and investors continuing to add to government bonds.
In addition, he argued that the reflation story is “not all one-way traffic” – meaning government bonds have remained attractive to some investors. “Some forward-looking economic indicators have been rolling over (from very high levels) and the ‘transitory inflation story’ is well known, so why worry about it?”
The chart below sums up a range of these forward-looking economic indicators, showing how many are pointing to a less-rosy outlook than they were just a few months ago. This may explain why government bonds, which tend to do better when the economic outlook is weakening, have held up over the past few months.
Source: Newton, Bloomberg July 2021
So while this explains, the recent strength of bonds, what does Brain expect to happen next? In short, he thinks investors need to be ready for increased volatility in government bond markets.
The table below shows a variety of market stresses that are watched by Newton’s fixed income team.
While they have been in “‘goldilocks territory” since the middle of 2020, many are now amber and a couple have gone red. Brain admitted this causing him “some concern” right now.
Source: Newton, Bloomberg July 2021
“For government bonds, we anticipate a consolidation phase for the rest of the summer, with inflation numbers trending down and central-bank demand remaining high. We also see fiscal support for the economy receding, with the removal of some of the emergency support packages,” he said.
“This support (through credit and income payments) has been significant, and not all of it will be replaced as economies open; for markets, it may offer more of a short-term catalyst for greater volatility.”
Given this, the BNY Mellon Global Dynamic Bond co-manager said it might be “prudent” for bond investors to tactically reduce any shorts on the US dollar and consider reducing emerging-market currency exposure. He added that it could also be worth considering adding to any call options on the US treasury market.
Brain finished: “The fourth quarter is where we see more significant problems developing for government bond markets as central banks will need to step up the rhetoric about removing the various financial support ‘punchbowls’ and renewed fiscal support will weigh on bond supply. Furthermore, China is now loosening monetary policy which may support global growth later in the year. We expect government-bond market yields to rise as a result.”