Is it time to own bonds?

While bond markets can be influenced by a whole range of factors, there’s clearly no doubting that monetary policy is the most important. Easing cycles typically cause lower yields, especially at the front end of the curve. Other factors, like currency movements, budget tensions and more, can interfere with the ability of yields to follow the monetary policy cycle, but, by and large, you can’t go far wrong if you follow the cycle.

Right now, most G10 central banks have begun an easing cycle and, those that have not, like the Reserve Bank of Australia should start soon. Only the Bank of Japan stands out as policy tightening here seems set to continue. But while it might appear that owning bonds is a sure way to make money for many months yet, there are clearly some pitfalls.

One is that central banks could call a halt, or a pause to policy easing sooner than anyone expects, and that will make yields race higher again. Another is that, while short-term yields might follow policy rates lower, the long-end could be buffeted by other factors, like budget concerns. Yet another issue is whether the performance of corporate debt could be imperilled by factors such as a sharp economic slowdown or restricted from outperforming due to already-tight credit spreads.

In the current environment, it looks as if all of these risks are at play. On the first of these, central banks have started to ease, but inflation is still generally above target and labour markets are still tight. This could lead to a far more sedate pace of easing than currently priced into the market and so imperil any fall in yields. The US treasury market faces an extra risk on this front, which is that a second term for President Trump after next month’s election could quickly lift inflationary concerns related to policy recommendations for mass deportations and higher tariffs. In fact, no matter who wins, there could be tensions in store for the treasury market, it would seem, as both candidates seem set to preside over notable increases in the budget deficit.

But how seriously should we take these threats? Not too seriously, at least not at this stage. For a start, policy rates are high and central banks are indicating that policy needs to be eased quite a bit. This suggests to us that, even if easing has to pause, it is unlikely to be at this early stage. And this, in turn, suggests that there is more scope for bond yields to fall before the risk of a notable turnaround kicks in.

When it comes to the prospect of a Trump presidency, there are a number of key issues. The first, of course, is that he might not win. A second issue is whether a Trump victory would lead to any quick reassessment of policy by the Fed. In short, will the Fed look a long way ahead, to the possibility of much tighter labour markets and much higher tariffs and decide straight away that it needs to tread more carefully with policy easing? Or will it not try to anticipate too much, continue with the easing, and only worry about Trump-related inflation risks if, or when, they start to be seen in the data – and that could be years away, if at all. Steve Barrow, Head of Standard Bank G10 Strategy, thinks it will be the latter.

“The bottom line is that we think the ‘power’ of the easing cycle will remain the dominant factor and it will allow bond yields to fall. The particular risks surrounding the US election seem likely to make euro zone bonds, or UK gilts a better choice than treasuries in our view and, in addition, we do not believe that dollar-funded positions in these bond markets will be undone by a significant rise in the dollar,” said Steve Barrow.