As you’re no doubt aware, conditions are ripe for a bond bear market.
Fortunately, equities (in the US at least) have thus far provided something of a buffer against the sharp repricing of yields. That said, we have to ask ourselves if the bond/stock returns correlation will ultimately turn positive and stay there. Expectations of fiscal stimulus-driven growth could very well give way to despair as the end of cycle dynamic combined with aggressively combative trade policies combine to hamper any notion that the current expansion can be extended beyond its natural life.
The fear is that the effect of adding fiscal stimulus to an economy at or near full employment will simply be to boost inflation, prompting the Fed to aggressively hike rates, driving the dollar and yields ever higher. This tightening of financial conditions could put the screws to global growth just as politics in Europe take a dark turn.
Below, find excerpts that speak to this rather inauspicious dynamic. The following is from an FT piece by Alberto Gallo, former RBS macro maven who has since left the firm to manage a fund designed to perform in the perverse world of negative rates.
The low for long era is over.
Central banks, fiscal activism and populism pricked the bond bubble in 2016. Next year will be a lot worse for bond investors, and the aftershocks of the burst will spread across many other assets.
Since the crisis, investors have been buying bonds for capital gains and equities for yield, trusting in the holding hand of easy monetary policy. However, today the central bankers’ hand is no longer there.
The economic equilibrium that quantitative easing (QE) created was always an unsustainable one. Monetary stimulus without appropriate fiscal action encouraged misallocation of resources to zombie firms and banks that should otherwise restructure.
There are few places to hide for bond investors in this environment. Even as QE infinity fades, the rise in inequality continues to provide fertile ground for politics of rage. Brexit, Trump and the recent No vote in Italy’s constitutional referendum may all lead to wider deficits, less structural reform and protectionist measures such as tariffs on international trade or limits to migration.
Fading monetary policy and fiscal activism are bad news for bonds, pushing yields and inflation higher.
The rotation out of coupon-generating assets has already started. Yet bond investors’ duration exposure remains high, at 6.8 years on average in October, according to IMF data. That is up from five years in 2008. With rates and risk premia at record lows and barely compensating for inflation, there is probably more pain to come for fixed-income investors before the grand finale.
