Challenging the Government Bond Bears

 In Market and Investment Insights

Co-Head of Strategic Fixed Income Jenna Barnard argues against the bearish narrative for government bonds, saying bigger risks lie elsewhere in credit markets.

Key Takeaways

  • As the business cycle continues to age, investors may want to consider the diversification benefits that longer-dated government bonds typically provide portfolios.
  • However, today’s prevailing wisdom suggests government bonds are at risk of a bear market due, in part, to global inflationary pressures and continued rate hikes in the U.S.
  • We believe these fears are misguided. Core inflation in developed markets remains largely unchanged and rate increases could be slowing in the U.S. On the contrary, we believe areas of corporate credits face the bigger risk of a correction.

Jenna Barnard: Today is December 5, 2018, and I wanted to provide an update.

So for the last year or so, John and I have been saying that it is a late-cycle environment. But as we move through this late- cycle environment, I wanted to talk about the next phase of the cycle, the downturn. Because when that comes, government bonds, even in the U.S., we think, will provide diversification. What is different at the moment is we have so many bearish narratives about particularly U.S. government bonds, such that most investors seem afraid to move into duration and have portfolios which are predicated that this rising yield environment will continue, even in the U.S. We don’t buy into that thesis. And I wanted to talk about three of these bearish narratives that we hear and why we think they are not supported by facts.

The first is technical analysis. There is this downtrend in U.S. government bond yields, which has been going on since 1981. Frankly, people redraw the downtrend line on this graph constantly and have done in every economic cycle. So there is no consistent line that dates all the way back to 1981 unless you use a logarithmic scale on your yield chart. If you do that, then the downtrend holds to the basis point at 3.26% in early October on 10-year U.S. yields. So I would be cautious about using technical analysis, getting trapped in a false narrative, and I would urge you to look more widely and particularly at that logarithmic chart. We think that kind of deterministic use of technical analysis to argue that we’re at the beginning of the U.S. government bond bear market is false, we have a different view, and it is potentially a huge red herring at this point in the economic cycle.

The second narrative we hear, which we just don’t think is supported by facts, there is a regime shift going on in inflation, that inflation is picking up around the world. That is not the case. Core inflation in the G7 is pretty much unchanged this year. The only G7 economy where core inflation has picked up is the U.S., but that was expected based on base effects and where the U.S. is in the economic cycle. Even U.S. core inflation has peaked at lower levels thant most analysts predicted this year. Headline inflation is obviously going to come down very rapidly with the decline in oil prices, such that it is probably mid-1% even in the U.S. early next year. So this inflation narrative is just not one that we see supported by the inflation data that is actually coming in.

The third narrative we hear is that this is a global government bond bear market. Again, that is not the case. Ten-year bond yields in a lot of countries are actually lower at year-to-date, Australia, Germany, somewhere like the UK is relatively unchanged. So it is very much a U.S. bond bear market, but we think it is in its late innings and we think that final spike in yields in the Autumn of 2018 was a buying opportunity. And frankly, we think the next phase of the cycle for a bond investor is actually going to favor conventional duration, conventional government bonds.

So I would urge investors to rethink some of these extremely bearish narratives you hear on government bonds, to look at portfolios, particularly portfolios that are predicated on a rising rate and rising yield environment, because we think the danger is in illiquid assets and areas of the credit market. To us, those look like the beginning of a more serious bear market and, frankly, probably where the bubble has been this cycle. Thank you.

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G7 = Group of Seven World Leaders
Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.
Foreign securities are subject to currency fluctuations, political and economic uncertainty, increased volatility and lower liquidity, all of which are magnified in emerging markets. Fixed income securities are subject to interest rate, inflation, credit and default risk. As interest rates rise, bond prices usually fall, and vice versa.

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