Fixed Income

The bonds market: a tantrum, a crash or a sell-off?

By Ilan Dekell
Head of Macro Sydney, Australia

Is it a tantrum, a crash or simply a sell-off? No matter what you call it, the sharp rise in bond yields that we have witnessed so far this year has been a cause for concern for all types of investors, whether they own bonds for income, capital stability or defensiveness.

To add to the concerns of investors, is that this has occurred as the Reserve Bank of Australia (RBA) has committed to buying more government-issued bonds, as part of their quantitative easing program, whilst at the same time the Australian government debt issuance programs have been revised lower as the recovery takes hold due to an improvement in the revenue of the Australian government.

Despite the supply and demand dynamics from the government and the central bank moving in favour of keeping yields low, yields have continued to push higher. This has been caused by a number of factors that have worked together to drive yields higher.

The backdrop: what’s happened?

First, bond yields are towards their all-time lows, offering very low returns, making them less attractive to hold. Secondly, the economy has recovered from the COVID-led recession, and the recovery has been faster and stronger than many expected six months ago both globally and in Australia. Additional US government spending, to the tune of US$1.9 trillion1, or a whopping 10% of US GDP, has further boosted growth and inflation expectations.

Furthermore, China growth was positive in 2020, whilst many economies recorded negative growth. This was particularly helpful for commodity demand and especially iron ore demand. Despite all the negative news on Australia-China trade tensions, Australian exports to China have been strong in both price and volume terms, mostly led by commodities. The Australian experience from COVID-19 was also much less impactful, driven by lower virus infections (and lockdowns) and aggressive policy support to the economy through various measures, particularly JobKeeper, reducing the amount of long-term scarring that often occurs with recessions.

With Australian yields very low, this has led to investors preferring to hold assets that benefit from an improving growth outlook. In doing so there is a natural bias to sell fixed rate bonds, which are defensive, and in turn, buy growth assets such as equities. This positive backdrop feeds on itself as defensive bond positioning is unwound, and carry trades linked to low yields are reduced, leading to higher fixed rate bond market volatility, and the sharp moves higher in yields we have seen.

Whether bond yields continue to move higher or not will depend on how the economy outlook unfolds, as well as how central banks choose to react to the improvement via monetary policy changes. For now, with strong economic momentum on the back of US government spending, and the opening up of economies from lockdowns, and border restrictions, the pressure to price higher inflation and ultimately higher monetary policy via higher yields seems intact.

Are bonds still attractive?
Nonetheless, it’s important to be mindful of other factors that determine the attractiveness of bonds, both in terms of their value but also their usefulness as an investment in a broader portfolio. It’s also essential to understand the attributes of a fixed income investment. Fixed-rate bonds or long duration assets are much more sensitive to a move in yields, losing value as yields rise, whilst short-duration and floating-rate bonds are less sensitive to a move in yields, whilst still earning income via coupon payments. These type of shorter-duration investments lower overall portfolio volatility relative to equities and longer duration fixed-rate bonds. If one has concerns of further moves higher in bond yields, consider investing into short duration fixed income that focuses on providing a stable monthly income stream, rather than traditional fixed income, that is more exposed to a shift in higher yields.

The RBA continues to keep the monetary policy cash rate at all-time lows of 0.10%, and whilst we don’t know the future path of policy rates with certainty, the RBA has stated that they won’t raise interest rates until inflation, based on their measures, is sustainably in the inflation target band of 2-3%. They have stated that they don’t expect this outcome until at least 2024 with unemployment needing to be closer to 4%, and wage growth above 3%.

Based on these measures the economy needs to make much progress. Unemployment rates were sitting just above 5% in 20192  and failed to drive wage growth and inflation higher. In fact, we haven’t seen wage growth above 3% since the China driven commodity boom where there was labour intensive capital investment and building of mining infrastructure that now sees high volumes of iron ore shipped overseas, albeit with a much lower mining labour force. With unemployment rates currently at 6.4%3, as well as a high underemployment rate, there’s a long way to go before we see wage growth above 3%.

With policy rates staying low for a long period of time, bond yields will be limited in how far they can move, given a 10-year bond yield should reflect future policy, as well as any premia related to the future uncertainty of policy rates. With an economic recovery in full flight and central banks doing everything they can do to get inflation higher, this premia or reward for taking on risk has been pushing yields higher. But the pace of growth in the recovery cannot be sustained. Governments cannot continue to spend at the same pace they have done so through the COVID crisis. Indeed, levels of debt globally across households, corporations and government will limit the level policy rates can get to, as any rise in policy rates will increase debt servicing costs, and in turn limit spending elsewhere.

Importantly though, as bond yields rise and equities rise, bond yields become more attractive, both on a relative and outright basis, restoring some of their lost competitiveness versus growth assets as a defensive hedge. Bond investments may not be as attractive as they were over the past decade as bond yields were falling, but they continue to act as a diversifier through the economic cycle, due to their innate attributes.

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Ilan Dekell, Head of Macro
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