Don’t give up on US treasuries

The bond sell-off: Some perspective is needed 

Bond markets have come under pressure as central banks hawkish talk has reached a critical mass, pushing yields higher in recent weeks. However, US bond investors should not panic. Fundamentals are still supportive for a low rate environment. In other words, there’s limited downside to US bonds. From a risk-reward perspective, investing in the “mother of all assets” has become more attractive recently given the latest sell-off.

In the wake of the recent bond sell-off, some perspective might be needed. The 10 year US Treasury yield has risen from 2,14% to 2,39% in less than 2 weeks, but is still below the highs of 2017 (2,62% in March). The primary driver has been hawkish central bank talk, with the ECB removing some of its easing bias in its statements and the Fed laying out a plan for a reversal of its unconventional stimulus (Q/E). Despite low or falling inflation in most regions, it seems hawkish signals from central banks have reached a critical mass, enough to make bond investors fret about a potential liquidity squeeze. But fundamentals do not justify dismissal of US government bonds at this stage.

First of all, the reflation hype is coming to an end, supporting bonds as an asset class. Although deflation scares are not expected to make a comeback, US inflation is likely to stay relatively weak and below central banks’ targets of 2% (see US inflation outlook chart). A supply glut is structurally weakening oil prices, which dampens headline inflation. Core inflation, on the other hand, is kept low by structural factors such as an ageing labour market and technological changes (robots). These factors are slow-movers, unlikely to change anytime soon. As long as inflation stays weak, there are fundamental limits to how much bond yields can rise (and prices fall).

Graph 1


Secondly, we are about to reach a cyclical turning point. According to our own indicators, growth is about to peak and likely to slow in the coming months – although from relatively high levels (see LHS chart). This is mainly reflecting high levels as such, tightening effects in China and Trump’s tax reforms being delayed (or derailed?). In light of elevated expectations, we are therefore likely to see some growth disappointments in the coming months or so, supporting “the mother of all assets” safe haven appeal. If the early signals from this indicator hold true, Treasuries should regain some ground relative to global equities (see RHS chart).

Graph 2


Graph 3


Why these hawkish messages from the Fed, given weak inflation below the central bank’s target and question marks on the cyclical situation? Is this a game changer for the decade-long bond bear market? Market participants shouldn’t ignore the shift in the central bank’s reaction function away from an easing bias to a more hawkish bias. We can only guess about the incentives behind this. Given the fact that central bank liquidity has pumped up asset prices since the great financial crisis (Fed balance sheet graph), some of the hawkish rhetoric probably aims at reducing financial excesses and therefore stability risks further down the road. As Fed chair Yellen stated recently, asset valuations are “somewhat rich”. In other words, the Fed might want to introduce some realism into markets.

Is this then the end of days for core government bonds? Far from it, in our view. As the LHS graph below illustrates, the Fed is planning to proceed very carefully when reducing its balance sheet. And given the fact that unconventional easing has supported risk assets more than relatively safe assets like US Treasuries, an unwind of unconventional stimulus – if overdone – would most likely also hurt risk assets more than US Treasuries. And don’t forget that the long-term factors holding down interest rates have not changed: High savings and a low growth potential due to demographics and poor productivity are very much in place.

Although the sell-off in rates might not be over yet, medium term we remain constructive on US Treasuries, especially the longer-dated bonds. This is still a bit out of consensus, but as a reminder, analysts have a habit of revising down there year-end target for US government bond yields over the course of the year (RHS graph).


Graph 4


Graph 5


About Nordea Asset Management
Nordea Asset Management (NAM, AuM 219 bn EUR*), is part of the Nordea Group, the largest financial services group in Northern Europe (AuM 332 bn EUR*). NAM offers European and global investors exposure to a broad set of investment funds. We serve a wide range of clients and distributors which include banks, asset managers, independent financial advisors and insurance companies.

Nordea Asset Management has a presence in Cologne, Copenhagen, Frankfurt, Helsinki, London, Luxembourg, Madrid, Milan, New York, Oslo, Paris, Sao Paulo, Singapore, Stockholm, Vienna and Zurich. Nordea’s local presence goes hand in hand with the objective of being accessible and offering the best service to clients.

Nordea’s success is based on a sustainable and unique multi-boutique approach that combines the expertise of specialised internal boutiques with exclusive external competences allowing us to deliver alpha in a stable way for the benefit of our clients. NAM solutions cover all asset classes from fixed income and equity to multi asset solutions, and manage local and European as well as US, global and emerging market products.

*Source: Nordea Investment Funds, S.A., 30.06.2017

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