The bond markets have seen rapidly steepening yield curves in recent weeks. Why has it been happening? And where will it all end?
It’s a tough time for James Bond fans, with the 25th edition of the franchise No Time to Die recently delayed for a third time, until October 2021. In the meantime, there is plenty of “bond” entertainment available on global financial markets.
While a world away from Aston Martins and Vodka Dry Martinis, the action on the bond market is even more spectacular with much greater sums at stake.
But as with any James Bond extravaganza, it can be a mistake to imagine that the big set piece at the start of the movie will be a pointer of things to come.
The opening scene
What’s got people excited in recent weeks are rapidly steepening yield curves. That’s financial jargon for when the gap between long-term over short-term interest rates is widening. A year or two ago, these curves were flat, or in some, cases inverted.
Bonds are measured by yield, which is the inverse of the price. So if the yields are rising in longer-dated maturities, that means prices are falling. Why does this matter to the average person and, more importantly, what can you do about it?
There are a couple of ways of looking at this issue. The glass half-empty view is that the bond market is sending an inflation warning signal. Inflation is considered bad for bonds because it erodes the spending power of the bond owner’s income.
The other negative is that higher yields on long-term government bonds can make stocks look less attractive. In other words, the prices you pay for future cash flow from shares don’t appear as good a deal as when bond yields were super low.
The bond market is expressing the view that with central banks pledging to maintain loose monetary policy, via near zero official rates and bond buying programs, and governments pledging to maintain high levels of spending and borrowing (by issuing more bonds), the greater risk is that long-dormant inflation will break out.
There is also concern that higher bond yields, by increasing borrowing costs at a time of high debt loads, could strangle the recovery before it begins.
The longer view
But that’s the pessimistic view. The flipside of this episode of yield curve steepening is it reflects growing confidence in a global economic recovery from the shock of the pandemic. With vaccines being rolled out and fiscal stimulus kicking in, investors are more confident about the outlook for activity. That point is that this isn’t necessarily bad for shares. In fact a more buoyant economy and profits is a helpful environment.
That view is also reflected in sharply higher commodity prices. Copper, often seen as a barometer of expectations for the global economy, has recently hit 10-year highs. Prices for iron ore, used in steel-making, is also near its highest in a decade. And oil prices have more than trebled from the near two-decade lows reached in April last year.
A second point is that some perspective on yields is due. When US 10-year Treasury bonds vaulted above 1.5% in late February, they had only returned to the levels where they were a year before. Bonds for some time now have been paying virtually nothing, so an adjustment was inevitable. By some measures, they would have to double again to 3% or more to threaten equity market valuations.
A third point is that inflation may not be the threat that the market imagines itself to be in any case. This is not the 1970s. The world economy is emerging from its worst recession since the 1930s. The greater threat in recent years has been deflation, not inflation. The pandemic has depressed incomes to below the levels they were pre-COVID and there is significant divergence across different economies.
Against this background, there is a good argument that what we have seen in the bond markets in recent weeks has been a knee-jerk reaction to a largely phantom threat.
Bonds’ eternal role
But even if the bond market has got it right about inflation, there is a fourth point to keep in mind. And that is that fixed income in a diversified portfolio plays a role beyond generating investment returns. As defensive, low volatility assets, bonds act as a kind of buffer in your portfolio and offset the wilder swings of equities.
Finally, consider this: Not every yield curve is the same. Some — like the US and Australian government yield curves – have been steepening much more dramatically than others — like the Euro and Japanese yield curves. As an investor, this means you have choices and can diversify your portfolio to suit. Steeper curves also represent an opportunity. A higher term premium implies a higher expected return.
Of course, bonds are not totally riskless. The premiums they offer come from their maturity or length they are issued for (longer bonds traditionally offer a higher yield) and their credit risk (the chance that the issuer won’t be able to pay you back).
The second of those risks is obviously significantly less if the bond issuer is a highly rated sovereign like the US government than if it is a sub-investment corporate borrower in a risky industry (as we saw with cruise lines in 2020). But recently, we have seen that first risk, maturity, show itself after a long hiatus.
Your exposure to bonds will depend on a range of factors, including your age, goals and risk appetite. Within bonds, your exposure to longer maturity or lower credit quality will also vary according to your individual circumstances and goals. These are decisions to be made in consultation with an adviser who knows you.
To summarise, bond markets have been adjusting in recent weeks. This reflects optimism about the global economy post-pandemic. The rise in longer term yields has shaken equity markets on the view their relative valuation will look less attractive and on the view that higher borrowing costs will stymie the recovery.
But a more buoyant outlook is not necessarily bad for equities. And, in any case, in a patchy recovery with plenty of spare capacity, we are unlikely to see a dramatic outbreak in inflation. Finally, even if the bond market is right, bonds still play a role in a diversified portfolio in dampening volatility and increasing the reliability of outcomes.
Ultimately, markets will do what they do. In the meantime, we can all look forward to No Time to Die.
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