Beware the Overheated Bond Market

October 24th, 2016 by

Amid an increasingly risk-off environment for investors, money has steadily flowed into the government bond market at an alarming pace over the last few years. This is especially true for U.S. Treasurys with a longer duration (10 years or more) as investors chase the higher yields they offer.

However, there’s reason to believe this market is getting overheated, meaning the long bull run in bonds could be coming to an end.

Economy, Inflation Improving?

One of the most readily apparent consequences of the stagnant economic outlook—both in America and abroad—has been the overcrowding into government bonds. Investors looking for safety have aggressively increased their exposure to fixed-income assets like Treasurys. This “crowded trade” makes bond prices more expensive and yields lower. With so many major financial institutions (i.e. “institutional investors”) caught on one side of this trade, a reversal toward rising bond yields could have a devastating effect.

Nonetheless, in the flight to safe ground, investors have been willing to accept paltry yields (like 1.75% for the benchmark 10-year Treasury note) because the opportunities for better returns are dwindling or involve far too much risk. This has become especially true in places where sovereign bond yields are near-zero or even negative.

This seemingly endless rally in bonds has been occurring simultaneously with a strengthening dollar—perhaps in spite of this development, you could say. While U.S. corporations worry about a strong dollar hurting their overseas revenues, this trend also makes Treasurys more expensive for foreign buyers. U.S. Treasury bonds are among the most popular assets for central banks around the world to hold as reserves.

The scattered signs of improving economic conditions aren’t great for bonds, either. If interest rates indeed go up in the U.S., as the Federal Reserve has been hinting all year without acting yet, then newly-issued Treasurys will have higher yields to adjust to the tighter interest-rate environment. Longer duration bonds would become more likely to incur a loss relative to inflation.

In fact, Frankfurt Trust’s head of asset allocation, Christopher Kind, says that “Central banks, after a long period of disinflation, are going to tolerate higher inflation. That is not good news for longer-dated bonds.” The Bloomberg Barclays sovereign-debt index suggest that a 1% (100 basis-point) increase in interest rates would cost global investors over $2 trillion in missed revenue compared to the newly-issued, higher-yield Treasurys.

Measures of inflation (at least those preferred by government bureaus) have also been picking up of late. In stark contrast to the disinflationary trend that has plagued the global economy, which especially hit the U.S. between the middle of 2014 and the beginning of this year, the Bureau of Labor Statistics (BLS) most recently reported that inflation over the last 12 months has been 1.5%—much closer to the Fed’s target rate of 2%. The irony, of course, is that this is not exactly exciting news for those holding the Treasury’s debt obligations.

 

The opinions and forecasts herein are provided solely for informational purposes, and should not be used or construed as an offer, solicitation, or recommendation to buy or sell any product.