Fixed Income

The conventional explanation from recent moves in bond markets is that global bond yields are collapsing because investors fear a global recession, triggered by the US-China trade war, slowing economic momentum in Europe etc. Our take is more nuanced. Global bond yields are collapsing in anticipation of aggressive central bank action to save economic growth from the aforementioned risks. That is why we’ve only seen a small wobble so far in risky assets (i.e. equities, credit, EM), rather than a material correction.

If economic growth really was to slow to levels that are consistent with the current levels of global bond yields, risky assets would have to fall a lot further. Instead, they are still holding up relatively well on the assumption that aggressive and pre-emptive central bank rate cuts will prevent the economic downside scenario from actually materialising.

Looking at past 12 month returns, it’s very unusual to see such a strong rally in conventional safe havens like government bonds, while risky assets also performed very well.

This apparent inconsistency between bonds rallying fiercely, while risky assets remain near the highs, can be explained by one thing … the assumption that central banks will save the day.

One chart to keep an eye on

We have seen record inflows to bonds, at a time when yields are already at record low levels and a record 24% of global bonds have a negative yield.

Everyone’s chasing bonds on the expectation that yields will keep falling and therefore the interest rate duration exposure inherent in those bonds will provide capital gains (lower bond yields = higher bond prices) to protect their portfolios if equities fall. This has now become the most crowded trade across global financial markets.

While it has worked so far, how well can it keep working going forward given that the more yields fall, the more unfavourably asymmetric the risk vs. return profile of duration exposure becomes? This asymmetry is what makes chasing bonds at record low yields (i.e. record high prices) very different to chasing stocks at high valuations.

This also begs the question as to whether these record bond inflows are based on considered analysis of risk vs. return dynamics or whether they are simply anchored to past performance.

Just because a position is crowded, doesn’t mean it’s wrong. However, history does tells us that when strong consensus expectations and crowded positions build up, the room for disappointment grows and a potentially violent re-pricing can follow if things don’t play out as expected.

Bonds are supposed to be the safe haven that protects portfolios when equities fall but may actually end up being the catalyst for the next equity drawdown if extreme investor expectations and positioning around the ‘lower for longer’ interest rates theme is disappointed.

On this point, the strategists from BofA Merrill Lynch produced the chart below and noted the following;

“The most important flow to know: annualized inflows to bond funds = staggering record $455bn in 2019; compares with $1.7tn inflows past 10-years; positioning danger is in bonds, not stocks or commodities”

– BofA Merrill Lynch, The Flow Show, July 2019

The outlook for bond markets

In short, our expectations are for more extreme volatility. The combination of record inflows to bonds and the one way consensus bet that rates can only go lower, at a time when bond yields are already eye-wateringly low, leaves global bond markets in a precarious position.

Anything that causes this consensus to be questioned, for example an unexpected uptick in inflation, could cascade into a violent bond market sell-off that then spills over into other markets.

Looking at the earlier chart, note that the previous peak in bond inflows was late 2017 / early 2018 … just before the bond market sell-off that triggered 2018’s global equity drawdown.

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Comments

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Adarsh Gowda

Great article and very thought provoking. Talks about a topic that is hardly discussed. Having taken benefit of bond rally thus far, this definitely makes me think of rebalancing my position for risks. Thanks Gopi for this quality content.