The role of US government bonds in portfolios has traditionally been to dampen volatility, but over the past month or so, despite the deteriorating economic outlook, the price of US Treasury bonds dropped at one point to a 17-year low, so what is happening to the world’s most liquid asset?
The fall coincided with sharp drops in the price of gilts and other developed market government bonds, with those economies being viewed by many market participants as being even more likely to suffer a recession.
The link between bond yields and the economic outlook, and the reason portfolio management theory is framed around the idea that bonds and equities move inversely, is best understood in the context of how a bond yield is constructed.
Phil Milburn, fixed income manager at Liontrust, says: “A bond yield has three elements: as an investor you want to be compensated for the expected growth rate of the economy during the life of the bond; then you want to be compensated for the expected level of inflation in the economy over the life of the bond; and finally, you want to be compensated for having your money tied up for the lifetime of the bond.”
One of the reasons long-dated government bonds are expected to perform well during a recession is firstly because as expectations of future growth rates decline, so the portion of yield needed to compensate the bond owner for economic growth falls.
An element of normality may now be returning to bond markets.
That causes bond prices to rise, because investors are keen to own yields that were derived from previously higher anticipated growth rates.
Additionally, if economic growth is deteriorating, inflation would usually be coming down, providing central banks with the opportunity to cut interest rates, which pushes up the price, and therefore depresses the yield, on existing bonds as investors rush to buy those and lock in the higher yields that are reflective of the previous inflation and interest rate expectations.
But while many of those conditions existed in the third quarter of this year, bond yields rose sharply, and so prices fell.
But what is happening?
There are two possible explanations; the first, which is favoured by many, including Matthew Rees, head of global bond strategies at Legal and General Investment Management, is that markets had priced bonds to reflect an imminent cut in interest rates as economic conditions deteriorate.
Rees says a combination of recent communications from central banks and economic data pointing to inflation being more persistent has caused a re-evaluation of market expectations around when a rate cut may come, and a sell-off in government bonds.
Rees says the scale and extent of the US government’s planned budget deficit reinforced this narrative, as that would mean an increase in the supply of bonds at the same time as rates are not being cut.
Bryn Jones, fixed income director at Rathbones, says one of the issues may be that the usual impact of higher interest rates has yet to be felt within the wider economy within the timeframe that would be expected.
He says those operating within that usual time horizon would be expecting a recession to already be a reality in the US and UK, and were positioned for such.
A recession of that kind would typically be expected to hasten the falls in inflation already seen in the economy and to rate cuts.
Jones says when the recession did not arrive, and so investors began to expect inflation to remain high, there was a scramble to sell longer dated bonds, which are more vulnerable to higher inflation, and buy shorter dated bonds, which offer more protection against inflation but are vulnerable to economic growth shocks.
David Lewis, an investment manager in the Merlin multi-manager fund range at Jupiter, says he has owned shorter dated bonds of late simply because he considered them to be cheaper than their longer dated equivalents.
Jones is another investor who was in shorter dated bonds and so has benefitted from recent market events.
He says his rationale for this was his belief that while a recession may come, his view is the data indicated it will not be before late 2024, and in such a scenario, he felt shorter dated bonds represented better value.
Supply and demand
The other theory as to why US Treasury bonds sold off so starkly relates to supply and demand dynamics in markets, and the other side of central banks’ policy responses to higher inflation.
During the global financial crisis, central banks instigated a policy known as quantitative easing, whereby they created money to buy government bonds.
The economic aim was to provide liquidity to the financial system, fund the deficits governments had built up in dealing with the crisis, and keep bond yields low, which encouraged capital into riskier assets and arguably fermented the sharp rises in UK property and equity prices even as economic growth was anaemic.
A further bout of QE was deployed at the start of the pandemic, but the onset of inflation in the general economy since then has prompted central banks to embark on a policy of quantitative tightening, which reverses QE by selling bonds into the marketplace, causing their prices to fall, and negatively impacting the valuations of riskier assets.
Central banks may have anticipated that by the time they came to do QT government budget deficits would be falling and so the issuance of new government bonds would be reducing, helping to ameliorate the impact of central banks selling their existing stocks.
Brian Kloss, portfolio manager on the fixed income team at Brandywine Global, is an advocate of this theory.
He says the volatility in the bond market caused by revised rate expectations was a feature of the first quarter of the year, but the most recent turmoil has, in his opinion, been the consequence of governments issuing extra bonds to fund deficits at the same time as central banks are selling bonds, while the professional investors are too concerned about the prospects for inflation to linger to buy the extra being issued.
Alberto Matellán, chief economist at MAPFRE Asset Management, says markets knew of the onset of QT and priced this in, but they only became aware of the revised inflation expectations around the end of August when the Federal Reserve dampened expectations around rate cuts.
Reversion to mean?
An element of normality may now be returning to bond markets, as the prices of long-dated government bonds have moved sharply upwards since the Hamas incursion into Israel and subsequent military actions, as investors seek a safe haven, though they remain higher than at the start of the third quarter.
David Thorpe is investment editor at FTAdviser