The day the bond bull market died

Janet Yellen © Getty Images
Janet Yellen: could yet throw a spanner in the works

2016 may just go down in history as the year that saw one of the most momentous investment events in a generation: the end of the bond bull market.

To cut a long story short, that’s 35 years of interest rates going down.

Now they’re going to start going up again.

I talk a bit about the implications below. But if you want to get a better idea of how this is going to affect you, you should subscribe to MoneyWeek magazine now.

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The end of the greatest bond bull market ever

Yesterday we were talking about the oil market.

While being jolly nice for anyone involved in pumping oil, we noted that soaring oil prices aren’t such fun for people who have to buy and use the stuff. Nor is it good news for prices in general – as input costs rise, output costs should go up too.

In other words, rising oil prices will contribute to inflation (at first, at least).

So what happens if inflation makes a proper comeback? We’re starting to see the signs.

The yield on the key US government IOU – the ten-year Treasury bond – rose above 2.5% yesterday, for the first time since 2014.

So is this the “real thing” or just another brief scare in the history of the long bull market in bonds?

July 11, 2016, was “the day that the greatest bull market ever in the bond market ended”, reckons Michael Hartnett, chief investment strategist at Bank of America Merrill Lynch.

That day, the 30-year US Treasury yield hit its lowest point on record – 2.0882%. (The 30-year bond is the longest IOU issued by the US government – so if you missed your chance to lend the US government your money for 30 years at just over 2% interest a year, may I congratulate you on a shrewd investment decision.)

Of course, on that particular day, US government bonds actually looked pretty good value compared to some. If you’d fancied lending money to the Swiss government, for example, they’d have charged you heavily for the privilege. Every single Swiss government bond, including the 50-year one, was trading on a negative yield.

Now, says Hartnett, you have “a massive inflection point taking place in the price of money, the most important thing in our financial markets”.

Is he right?

Like everyone else in the market, I don’t have a crystal ball. And I’ll be the first to admit that I’ve been calling this bond market a bubble for a long time.

That’s because it is a bubble. I don’t think that’s a controversial thing to say. Say a time traveller visited us from back in 2009, and they had a look at today’s global growth figures, inflation data and stock market values. I guarantee you that there’s no way they would believe you if you told them that vast swathes of the bond market were trading on negative yields.

Negative yields make no sense given the prevailing conditions. They’re pure extrapolation – “prices have been going up for so long that they must keep going up” style stuff. Bubble thinking.

But identifying a bubble is one thing. Calling the turn is much, much harder. Japanese government bonds (JGBs) are well known as a place where foolhardy money goes to die – “shorting” JGBs has been seen as a “widow-maker” trade for decades now.

So why now specifically?

It’s the real thing

I reckon this is the turn in the bond market we’ve been waiting for. Something has changed.

Markets were already getting edgy before the Brexit vote happened. At the end of 2015, the US Federal Reserve raised interest rates. The bond bull’s card was marked.

But then we had a “China deflation” panic at the start of the year, which was rapidly followed by a post-Brexit scattering to safety. July 11 marked the nadir of that particular fear trade.

With the Brexit panic over, investors started to look again at the state of the world. They realised that whoever won the US election, they were going to be a big spender, rather than a faux austerity monger.

They twigged that Brexit would give the UK government an excuse to move on from monetary policy. They noted that the Bank of Japan was handing over the baton to the Japanese government.

They saw that the five-year bear market in raw materials prices was ending. They noticed that the only dud banking sector left in the world was in the eurozone.

That all points to inflation, not deflation. And as Patrick Hosking notes in The Times, if we have indeed passed “the point of peak anxiety about deflation” then there are “profound implications, not just for prices and borrowing costs, but also for investment flows and the appeal of riskier assets like shares and commodities”.

If the Fed does raise rates tomorrow, then that will simply “add to the evidence that the pendulum, after a 35-year swing in one direction, really is heading back the other way”.

Spanners in the works

Of course, as we always say, no market – bull or bear – moves in a straight line. So don’t be surprised to see a pullback in yields at some point, particularly if there’s any hint of a deflation scare.

The Fed might also attempt to throw a spanner in the works, although that’ll be harder – if the Fed is more dovish than expected, that’ll just raise inflation expectations. If it’s more aggressive than expected, that might panic markets but it’ll also drive up rate expectations.

And it’s possible that things could turn around again. Another big scare in the eurozone could have people scurrying for the safety of Treasury bonds again. However, next year’s events in Europe could also be surprisingly bullish, depending on how the elections turn out.

For what it’s worth, Hartnett reckons that as inflation and bond yields rise, “the big fun will be in Japan, will be in Europe, it’ll be in oil, it’ll be in value stocks, it’ll be in small cap”.

We outlined our own views – which aren’t too far away from those in some ways – in the current forecasts issue of MoneyWeek magazine. Sign up now.

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Merryn

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