In the past few weeks, we have seen a dramatic sell-off in global bond markets, which had some market commentators suggesting that the 34-year bond rally is coming to an end. In our view, although we will see bond yields rise this year as the US Federal Reserve (Fed) starts to tighten policy, this doesn’t necessarily signal the end of the bond market rally.
German Bunds have been the major driver of global bond markets for the past year and the trend is continuing. Since the European Central Bank (ECB) publicised the intention to increase its balance sheet using public debt, US Treasury yields began to fall in line with Bund yields. US Treasury yields were supported by lower Bund yields, which drove 10-year US/German spreads to historically wide levels. In addition, the US dollar started appreciating due to tightening monetary conditions in the US as the Fed began to taper its asset purchases.
It has been our view for some time that until Bund yields began to rise, there could be no major sell-off in US Treasuries. This has been borne out over the past few weeks as global bond yields have risen in line with the sell-off in Bunds. With improving Eurozone economic data, investors started to worry about how long the ECB’s quantitative easing (QE) programme would last, which prompted a reassessment of Bund valuations. The resulting sell-off reversed the bull flattening we had seen in 2014 and had implications for bond markets globally.
The sell-off was most extreme in the 30-year Bund, with the spread between German 10-year and 30-year bonds rising quite sharply, steepening the yield curve. As the chart below shows, the US 10-year rate was affected by the Bund movements and started to rise at exactly the same time as the German 10-year/30-year spread began to increase.
US 10-year bond yield vs. German 10-year/30-year Bund spread
Various factors remain supportive of bonds
If, as seems possible, much of the sell-off is due to an unwinding of positions, especially stale QE trades, we must be cautious about predicting the end of the road for bonds. Currently, there are various factors that remain supportive. The ECB’s bond buying only came into force in March and is thus likely to continue for some time yet, which should be supportive of the Eurozone bond markets in the medium term, particularly in the front end of the yield curve. Although Eurozone growth has begun to improve, it remains in need of assistance. In addition, this Eurozone growth is occurring at the expense of non-Euro countries due to the Euro’s depreciation. The trade balance between Europe and non-European countries is widening, which is good for Europe but will affect growth in other nations and so will not be as stimulatory for world growth as one might expect.
We still expect the Fed to start raising interest rates in September/October, although the pace and extent of hikes will be data-dependent. Current economic data releases indicate some weakness in US growth, although this may be due to transitionary factors, such as the poor winter and port strikes. Even if growth does improve, it is questionable whether it will bounce back to the strong levels seen in mid-2014 given the fall in oil prices and strong US dollar. This would slow the pace of rate rises and should keep Treasury yields lower for longer than might have been expected at the start of the year.
The US dollar has weakened recently as the market focused on weaker US data and started to unwind expectations for rate rises. However, if the Fed were to be viewed as more hawkish, the US dollar would likely rise and the yield curve would flatten again. The US dollar is therefore likely to act as a circuit breaker to higher or lower Treasury rates based on US Fed policy, which may dampen US Treasury volatility. With the Fed expected to raise rates this year, the market will likely start looking to sell on rallies rather than buying on sell-offs (which was last year’s strategy).
Conclusion: Bond markets should recover from recent volatility
With many markets having rallied from major support levels when they were in highly oversold positions, we believe that bond markets should stabilise or rally from current levels. However, it is unlikely that German Bund yields will reach the lows of April again in this cycle.
In our view, the first US rate hike will be in September/October and we forecast that the 10-year US Treasury yield will reach around 2.40% by the end of the year. The forecast for 10-year German Bunds depends on the sustainability of Eurozone growth but potentially we could see a 1.0% yield by December.
In terms of currency, we should see a rebound in the US dollar as we get closer to the Fed’s potential rate hike in September/October and continued depreciation in the Euro while the ECB’s QE programme persists.