2019 has seen relentless rallies in bond and equity markets. Yields have fallen despite the ebbs and flows in risk sentiment and, remarkably, even as equity markets are making all-time highs. How do we explain the record highs of US equity indices, with global ones not far off, while US 10-year bond government bond yields are back down to around 2 per cent? Bond yields in Europe are even lower, with German and French government bond yields at record lows and in negative territory. 
A major driver of the bond market rally has been the escalation in US-China trade tensions which has created economic uncertainty and is causing growth to slow. A lingering risk is for a further escalation of the dispute which could exacerbate already visible signs of corporate caution. This could ultimately lead to a slowdown or, if prolonged, a recession.
The positive rhetoric on trade at the recent G20 summit was welcomed by markets. But, the lack of details and a sense that the truce between the US and China remains fragile, is keeping uncertainty high. The temporary truce may reduce near-term economic downside risks but it does not introduce major upside for growth or risk assets. Plus near-term relief on the trade front appears to have been sidelined by economic data showing that global growth momentum has slowed.
Trade uncertainty is having the greatest impact on the industrial sector, where sluggish global capital expenditure growth has reduced global goods demand, leaving manufacturers with high levels of inventory. While there are pockets of stabilization in the data, particularly in the US, momentum remains weaker than in Q1.
Continuing trade uncertainty and its impact on activity data has spurred a global central bank policy response which is also pushing yields lower. First, there is the US Federal Reserve, which has embraced the case for “insurance” rate cuts to guard against further growth risks. It’s now widely expected that the Fed will cut interest rates a few times this year, even though the US economy is holding up much better than most.
The European Central Bank (ECB) is also finding itself drawn back into the quantitative easing camp. Growth in Europe has consistently disappointed, stemming from the weakness in global trade. This has caused the ECB to reluctantly acknowledge that the slowdown is not transient. The ECB has also been fairly explicit about the need for further policy easing, although how much more ammunition it has left at its disposal remains to be seen.
Dovish central banks, low realized inflation and the risk that the trade conflict between the US and China flares up again has changed the relationship between bond yields and equity market performance.
Historically, as risky assets performed well, bond yields would rise. But it’s interesting to note that over the last six months, this relationship has changed. Bond yields have fallen in line with negative headlines around trade tensions but failed to rise meaningfully at signs of relief in trade discussions. This implies that while there may be a near term de-escalation of US-China trade tensions it may not be enough to shift yields materially higher.
With the US 10-year Treasury at 2 per cent and the German bund at -30 basis points, global government bond yields may have overshot to the downside. Yields do appear to be pricing in more of a downside economic outlook than is warranted by underlying fundamental data. But, in a world where central banks are eager to cut rates pre-emptively, it’s hard to “fight central banks” by being short duration. Moreover, from a multi-asset perspective, duration still provides ballast to asset allocation positioning, even at these low yields.
So how does this fit together with strong equity markets?
The truth is that equity markets do like central bank policy easing and can often ignore deteriorating economic fundamentals for a while, as policy is being eased. Lower interest rates make equities look more valuable in comparison, plus there’s the hope that policy easing will eventually revive economic growth. However, history tell us that this can only go on for so long. Unless growth recovers, equity markets look vulnerable. If we do not see a concrete resolution to the trade dispute over the next few months, as well as an associated revival of global growth, equity markets look increasingly vulnerable even in light of falling interest rates and dovish central banks.
Thushka Maharaj is global multi-asset strategist at JP Morgan Asset Management. The views expressed above are her own and should not be taken as investment advice.