Government bonds are typically less racy than other asset classes, such as equities. Not so this past couple of weeks, as the yields on US Treasuries – which move inversely to prices – have surged to multi-year peaks and become the focus of market attention.

 

The US move has dragged developed-market bonds lower elsewhere and has had knock-on effects on other asset classes. Emerging market equities have slipped yet again, but emerging market debt has been surprisingly resilient in the face of the latest onslaught.

 

 

Most market commentators typically cite three catalysts for the yield spike:

 

  • Strong US economic data, which suggested the Federal Reserve (Fed) may continue to tighten policy at a relatively brisk pace

  • Bullish remarks on the economic outlook by Jerome Powell, the Fed chair, and his colleagues

  • The pending increase in US government bond supply due to the Trump tax cuts and the unwind of the Fed’s balance sheet

 

These are undoubtedly important, but we believe two other factors have also been at play, denting institutional and overseas demand for US government paper. The first is the fact that US pension funds are likely to buy fewer bonds in the coming months, as a corporate tax incentive that pushed companies to shore up underfunded pensions ended mid-September.

 

The second is that Treasuries have become far less interesting to Japanese investors on a hedged basis. Japanese investors wanting to immunise their holdings against fluctuations in the value of the US dollar have to pay a cost for doing so. That cost now stands at over 2.75%, more than offsetting the differential in yields between the two government bond markets.

 

 

However, within the Asset Allocation team, we favour leaning against the current market trend – and as a result have increased our tactical stance on duration (sensitivity to interest rates) from the underweight position we have held since May to neutral. This is for the following reasons:

 

  • From a price perspective, we believe this is the best opportunity to add US duration risk in four years and the best to add UK duration in four months

  • Money market futures are now pricing in a US interest rate trajectory for the next 12 months within 25 basis points of the Fed’s own outlook, indicating that policymakers and markets are unusually aligned

  • The market consensus, particularly evident in buy-side surveys, has shifted again to underweight duration-sensitive assets. This means there could be sharp moves in the other direction, if investors are wrong-footed

  • We still lack convincing and persistent evidence that higher yields are negative for equities (and still see long duration assets as an efficient hedge to our long risk-assets exposure). Lars wrote a great blog in June that provides a summary of why equity investors should not worry too much (yet) about rising interest rates

Treasury yields are now close to our estimates of fair value, making it time to dial down (not up) the pessimism.