Donald Trump’s shock victory in the US presidential election has amplified investor expectations that markets are facing the sternest test of recent years to a three-decade rally in global sovereign debt prices.
Following the initial shock that greeted Mr Trump’s win, yields on US Treasury debt rose on Wednesday as investors anticipate a programme of large-scale fiscal stimulus that will ultimately spur stronger inflation and higher interest rates.
An improving outlook for the global economy had already triggered a shift in investor portfolios that propelled yields in Treasurys and gilts to four-month highs, as investors started to demand larger risk premiums to hold assets that pay out a fixed income.
Market strategists at Deutsche Bank, including Tom Pearce, say the new Republican president is likely to exacerbate this trend – forecasting a rise in 10-year Treasurys from 1.9 per cent to 2.4 per cent by 2017.
While markets have experienced price snapbacks before – most notably the “taper tantrum” in 2013 triggered by concerns of US stimulus dwindling and the “bund tantrum” of 2015 amid a rebound in oil and commodity prices – neither was accompanied by an increase in inflation expectations.
Acute consternation
Rising employment, higher oil prices, and in the UK a sharp fall in the pound, have all contributed to the uplift in inflation prospects which is shrinking demand for bonds that currently pay a low fixed rate of interest to holders.
The question causing acute consternation is how this will play out after such an extended period of low interest rates and central bank bond buying that has encouraged record levels of debt and pushed investors to buy debt with a lengthy maturity.
Rising inflation means investors expect coupon payments and principal repayments to lose more of their value, resulting in a fall in bond prices and rising yields. Prices for longer-dated debt suffer acutely when yields are rising and this duration risk looms large for many portfolios if inflation accelerates.
In turn, as losses incurred from rising yields intensify, investors may well seek an exit from crowded trades, causing market upheavals.
For those not convinced, Peter Schaffrik at RBC invites investors to play a game of spot the difference in the US Treasury market.
In the bond sell-offs of 2013 and 2015, the difference between the nominal yield on 10-year US Treasurys and the real yield (which strips out the rate of inflation) was minimal, meaning market expectations of inflation were almost non-existent. Today that gap is expansive.
“This is the kernel which, if driven forward, could see markets leave their yield lows behind,” said Mr Schaffrik.
Inflation-protected bonds
Fears about the damage wrought by inflation have propelled a flood of money into inflation-protected bonds, with more than $1 billion (€918 million) poured into the funds in the week to October 26th – the second-largest weekly total on record, according to data from EPFR.
In the space of three months, 10-year gilt yields have jumped by close to 60 basis points, while bunds and Treasurys are up more than 20 basis points as prices fall and the historic low yields markets traded at during the summer fade from view.
In the US, the Fed is indicating a willingness to raise interest rates in December amid the pick-up in inflation. The US five-year break-even rate, a market indicator of inflation expectations, has risen to its highest level in almost a year.
In the UK, that rate has climbed above 3.5 per cent, from 2.9 per cent in early summer, meaning the market is pricing in persistent upward pressure on prices as the sharp fall in sterling raises import prices.
Kacper Brzezniak at Allianz Global Investors believes market forecasts for inflation have become almost outlandish – with break-even rates far ahead of Bank of England expectations.
On the other side of the equation, the governments and companies that borrowed at low rates could face a crisis if yields suddenly increase and their debt payments jump.
US debt
US debt has almost doubled in size since the financial crisis and is approaching $14 trillion (€12.9 trillion). UK debt is at a record £1.5 trillion (€1.7 trillion) while euro-zone government debt hit a high of €9.5 trillion at the end of last year.
In total, the International Monetary Fund puts world debt at a record $152 trillion and has warned that the burden could trigger a fresh global financial and economic crisis if not addressed.
Laurence Mutkin, global head of rates strategy at BNP Paribas, points out that this comes just when governments are advocating infrastructure investment, which could mean more borrowing.
But, he adds, there are deflationary pressures in play which could keep a ceiling on bond yields. Opec may yet fail to reach a deal, meaning oil prices could fall; central banks in Japan, the UK and euro zone are still buying bonds; and the Fed is not yet ready to reduce its $4.45 trillion Treasury holding. Longer-term, the demographics of an ageing developed world mean demand for secure, income-paying bonds in pensions will not disappear.
“The debt supercycle is still in play,” he said.
"That's not to say you can't have nasty sell-offs and the inflation expectations are different this time around. But nominal yields and break-evens are still at extremely low levels historically – even after this rise. It's going to take more than this to break a three-decade trend." – (Copyright The Financial Times Limited 2016)
