America’s becalmed bond market

The eerie calm in stockmarkets has hogged the headlines of late, but “equities are not the only becalmed asset class”, notes Robin Wigglesworth in the Financial Times. The Move index, used to measure the implied volatility of the US Treasury market, is now at a three-year low. “This looks peculiar.” US government debt is “subject to fierce cross-currents that should arguably produce some turbulence”.

On the one hand, “there is plenty to back bullish views”, as Scott Dorf points out on Bloomberg. In a world of low and even negative interest rates, investors remain hungry for yield and although the 2.2% offered by ten-year Treasuries looks pathetic, compared to their German counterpart yielding 0.35%, it’s well worth buying.

But then again, says Wigglesworth, the US economy “looks in reasonable shape”, the labour market is “taut”, and the US Federal reserve is tightening monetary policy. Higher interest rates imply lower bond prices. A steady source of demand – ongoing quantitative-easing programmes in the eurozone and Japan, which spill over into the US market – may be the best explanation for the lack of volatility.

Whatever the cause, this stand-off can’t last indefinitely, Kathleen Gaffney of fund manager Eaton Vance tells Barron’s. “Our concern is… the amount of uncertainty that is not priced into the market… it’s going to lead to greater volatility.” Geopolitical jitters could reinforce a key danger: the Fed falling “behind the curve” on inflation. Political problems, and their possible impact on market confidence, could prompt the Fed to keep rates on hold, increasing the scope for a shock jump in price rises. Inflation “could tip the ship”.

There is ample scope for turmoil, reckons Albert Edwards in a Societe Generale note. There has been an “unprecedented build-up in speculative long positions”. Extreme positioning like this often leads to “sudden sharp reversals”.

But if you’re worried about bonds, think twice before jumping into equities, says James Saft on Since 1871, “the equity-bond correlation has been close to zero”, meaning bonds have been a very effective portfolio diversifier. However, with correlations now much higher, if bond volatility does return, it is likely to increase in both markets simultaneously and null the diversification value of bonds. The upshot?

“Cash may now be in a rare period when it offers better portfolio protection and diversification than bonds.”