Bonds: a new bear market?
Recent bond market performance has caused some commentators to call the start of a bear market, but when there are significant market corrections, it is important that investors remind themselves of where markets were before the weakness and why.
There are a number of reasons that bonds have become so expensive. Growth expectations in Europe, at the start of 2015, were extremely low. The reason that the European Central Bank (ECB) announced its quantitative easing (QE) scheme in January was to reverse this trend of negative macroeconomic data. Inflation expectations for the region were further weighed down by the persistent oil price falls which began in mid-2014. Investors, knowing that the ECB would be buying bonds until 2016, were forced further and further along the yield curve; pushed into 10-year, 20-year and 30-year bonds to find a return. However, the buying support went too far and in April, the 10-year Bund was yielding just 7 bps. Even with no expectations of economic growth or inflation at all for the very long-term, bond valuations at these levels reflected absolutely no risk that forecasts for economic growth or inflation could be wrong.
However, eurozone growth began to build once more in the first quarter and the oil price regained some ground. The growth we are seeing now probably has little to do with the ECB’s QE programme. It is likely, instead, to be the culmination of the ECB’s introduction of negative deposit rates, the Targeted Longer-Term Refinance Operations (TLTROs) and the finalisation of the Asset Quality Review which had kept capital shored up in Europe’s banks. All of these initiatives were introduced last year, and all were created to free up capital to be spent and invested.
Investors have woken up to the fact that bond prices moved to absurd levels between January and April. With oil prices now recovering, growth returning and ECB QE set to continue, some of the interest rate and inflation risk has been built back into bond prices during the bond market setback.
So where do markets go from here? We feel it is important to highlight that we do not believe this is the start of a sustained fixed income bear market. Interest rates in the US are still effectively zero and are negative in Europe. Until there are changes to these policy rates, cash is not an alternative for investors. Bonds, even with low yields, are comparatively alluring.
If and when interest rates do start to rise, then the question for investors will be whether bonds are still worth the risks they represent, but not quite yet.
Gareth Isaac – Fund Manager, Fixed Income – Schroders