Bond market shoots first, asks questions later

By:
Louise Bowman
Published on:

The election of Donald Trump prompted a vicious sell-off in global bonds. Investors face the new year with warnings over volatility and inflation ringing in their ears. Will it be as bad as they think?

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Working in the bond markets can be pretty exhausting. If a burned out trader had decided to take a year-long nap on December 1, 2015 with the 10-year US treasury at 2.24%, he or she would have woken up on December 1, 2016 with the UST 10-year at 2.34%. So, nothing much happened last year, right?

Wrong. So much happened it is hard to know where to start. While our bond trader was sleeping, the UST 10-year hit an all-time low of 1.50% in July 2016, the UK voted to leave the European Union and the US elected a reality TV star as its next president. With this as the backdrop, looking forward into 2017 is a fool’s errand – quite clearly anything can happen.

By mid-December, the global aggregate bond index had lost $2.4 trillion of market value since Trump’s election, suggesting that his proposed fiscal stimulus will translate into almost immediate growth and inflation.

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Arvind Rajan,
PGIM Fixed Income

"It is hard for the markets to price in the protectionist agenda, so they have priced in Trump without the bad stuff," says Arvind Rajan, head of global and macro at PGIM Fixed Income in New York. 

"A big dose of humility is in order here," he adds. "When rates have moved so far and so fast you have to respect that. But the market seems not to be thinking about tails. It is clear when you look at the VIX near record lows that these are not being recognized. There is a fat deflationary left tail to all of this and if there is a supply-side shock to commodities – that could introduce right tail risk as well."

The bond market rout rolled on throughout December and a 25bp rate rise by the Fed was fully priced in by mid-month. While the Fed is likely to continue hiking in 2017, the bond market reaction to Trump still seems exaggerated, given how low rates are compared with their long-term averages. 

"Issuers were not complaining about interest rates a few years ago," says Brendan Hanley, co-head of global investment grade capital markets at Bank of America Merrill Lynch (BAML). "An increase in interest rates from 1.5% to 2.45% is only a dramatic increase over a very narrow timeframe."   

The world is short growth and long cheap capital. Even though rates are rising, there is going to be cheap capital, by historic standards, for some time to come 
 
- Alasdair Warren, Deutsche Bank

The bond market is, however, treating it as a dramatic increase and is stampeding for the exit. Following 39 continuous weeks of outflows from the US equity market before the US election, there were $40 billion of inflows in the two weeks immediately following it, the lion’s share of which came out of bonds and ETFs. 

"Yields will rise further. This is the beginning of the unwinding of the global carry trade," says Robert McAdie, global head of strategy at BNP Paribas.

The last few weeks of 2016 were certainly rough for many fixed income and credit investors.

"When rates are falling, no one cares about fixed rates," says one. "But when they start rising, suddenly people who you thought were only interested in spreads start worrying about rates." 

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John Beck,
Franklin Templeton

John Beck, director in fixed income at Franklin Templeton in London, believes the reaction has been understandable: "We had a fall in interest rates before the election. If the 10-year UST is at 1.75%, there is not a lot of yield there to protect you against volatility. So it is understandable that you shoot first and ask questions later." 

Nevertheless, at the end of 2016 the bond markets were priced for an outlook that is by any measure unlikely in 2017.

"Look at Treasury forwards and the one-year 10-year is at 3.5%, which is a big reach," says Rajan. "That is likely unattainable. It is unlikely that you will be able to substantially increase inflation and potential growth enough for long-term interest rates to rise much from here." 

The election of Trump heralds a brave new world for the bond markets, but that does not mean the end of low rates – the long-term average rate of the UST 10 year is 4.59%.

"The world is short growth and long cheap capital," says Alasdair Warren, head of CIB EMEA at Deutsche Bank. "Even though rates are rising, there is going to be cheap capital, by historic standards, for some time to come."

Taper trepidation

Europe was shaken by the surprise reduction in ECB public-sector purchase programme (PSPP) monthly purchases announced by Mario Draghi in December. The decision to extend the duration of the QE programme but reduce monthly purchases was a taper of sorts – and totally unexpected by a market already shocked by Trump. 

One banker speaking to Euromoney before the announcement of the decision pointed out: "Central banks have made and broken the markets. What the ECB decides to do next year will be key. Any suggestion that they will taper will crush the markets." 

Others saw the move as more of a rightsizing of the programme.

"The fundamental reason for reducing the pace of monthly purchases is that €80 billion in asset purchases is too high, given the improving macroeconomic backdrop, especially as risks of deflation and de-anchoring expectations have become more of a tail event relative to the first quarter of 2016," says Philippe Gudin, chief economist for Europe at Barclays. 

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It is true that when the PSPP was increased at the beginning of 2016, this was presented by the ECB as a frontloading of QE.

European yields have risen on the back of the Trump victory and duration risk is now a big factor. As McAdie at BNP Paribas notes: "Yields in Europe are rising because the global term premium is rising." 

This has muted one of the more extraordinary features of the market during 2016 – negative-yielding corporate debt.

"The volume of negative-yielding corporate debt in Europe has reduced significantly from a high of €195 billion to €55 billion," says Jeff Tannenbaum, head of EMEA debt capital markets at BAML. "However, in a historical context, if you are at zero or close to zero rather than negative rates, you are still in a pretty good place as a borrower."