Government bond markets “are supposed to be the accountants of the financial world: calm and steady”, says The Economist. But recently, they have been frightening the horses. On 7 June, the yield on the ten-year US Treasury bond moved above 5.05%, breaking a downward trend that had persisted since 1987 amid growing confidence that inflation had been vanquished. That prompted further bond selling, sending the yield to 5.3%; three weeks ago it was 4.7%. Bonds guru Bill Gross said he is now a “bear market manager” after 25 years as a staunch bull.
The US jitters sent Government bond yields up in the UK and Europe, with ten-year gilt yields hitting a ten-year peak of 5.49%. Gilts have dropped by 4.5% since January – “a significant correction for these normally stable investments”, say Henderson Global Investors. The bond slide wiped around 2%-3% off major equity markets, although they have since largely recovered as yields have stabilised.
So what caused the fright? It wasn’t an inflation scare: inflation-protected Treasury bond prices aren’t reflecting fears of rising prices. Concerns over Asian buyers paring Treasury purchases may have played a part – in April they preferred equities and corporate bonds to treasuries, say Michael Mackenzie and John Authers in the FT – but the accompanying uptick in the dollar suggests that’s not the full story.
Instead, evidence pointing to a stronger global and US economy has been growing, which implies higher interest rates. One major factor is that investors realised “they had grown too complacent about risk”, say Mackenzie and Authers. Long-term rates have converged with short-term rates and investors have finally decided that they deserve higher real yields to compensate for holding long-term bonds. Still, bond yields have been “extraordinarily low” in recent years; the market slide has simply brought them back to “more ‘normal’ levels”, says the FT’s Gillian Tett.
Government bond yields are the foundation on which all asset values rest. A rise in the yield on risk-free securities implies higher yields, and lower prices, for riskier assets ranging from mortgages to emerging market and corporate debt. “Cheap money underpins everything,” as Dan Roberts notes in The Daily Telegraph. Pricier credit poses a threat to the mergers and acquisitions boom that has sent equities to new highs: private-equity groups will find it harder “to pay top dollar for publicly listed companies”, says Richard Beales in the FT. That’s bad news for “deal-charged stockmarkets”.
Higher interest rates also increase the cost of servicing corporate debt, lower the cash available to shareholders and put pressure on stock valuations by pushing down the present value of future profit streams. They also make bonds look more appealing than stocks when the two asset classes are compared. In this context, Morgan Stanley notes that a comparison of the UK market’s dividend yield to the gilt yield shows that stocks are at their most expensive in 20 years. A more usual comparison, between the gilt yield and the earnings yield – the inverse of the p/e ratio – suggests stocks are still attractive.
The end of the cheap-money boom may not be here yet: bond yields and stocks have steadied and emerging market credit spreads remain narrow. But bond yields hardly look set to reverse course. Concern over Asian central banks’ diversification of currency reserves, and inflationary pressure as China ceases to be a deflationary force, are two factors that could put pressure on bonds. “If yields rise further, the herd may start to run,” says Colin Lundgren of River Source Institutional Advisors. Whether the easy-money bubble ends now or later, the writing, as Roberts puts it, “is on the wall”. Tim Price of UBP’s advice to investors is that “cash looks more and more like a solid asset for our brave new world – the true ‘risk-free’ rate.”
For more from Tim Price, see his investment email service, The Price Report