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.
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, andtherefore 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.
