More steam left in the bond rally

Kathleen Brooks
IT’S A case of how low they can go for bond yields. After another week marked by disappointing jobs and manufacturing data in the US, investors ploughed into the relative safety of government debt, pushing yields to record lows.

But is this an opportunity for spread betters? While it’s true that bonds have been in a 30-year bull market – interest rates have fallen dramatically since the 1980s and because bond yields move inversely to price, this has meant that bond prices have been steadily rising – there is a growing chorus who argue that it’s too early to call the end of the rally.

They argue that three factors could still keep bond yields low, or might even cause them to fall further: firstly, the mass-scale de-leveraging that took place in the aftermath of the credit crunch still has further to go, which should depress demand and keep a lid on growth for the foreseeable future; secondly, this is causing a threat of deflation in all the major economies and lastly, quantitative easing by central banks has increased buying pressure in the government bond market.

The consultancy Capital Economics lowered its forecast for government bond yields at the end of last week. It now predicts that 10-year yields will end the year at 2.5 per cent in the US (currently yields are 2.57 per cent), 2.25 per cent for the Eurozone (currently yields are 2.31 per cent) and 2.75 per cent for the UK where yields were 3 per cent on Friday. “The current low levels of bond yields are consistent with the prospect of a very long period of near-zero short-term interest rates, low or negative inflation, and lacklustre returns on other assets that increase demand for the safety of government bonds,” it wrote in a note to clients on Friday.

But, with inflation currently at 3.1 per cent in the UK – above the Bank of England’s 2 per cent target – can deflation really be that much of a threat? Yes, say analysts at Royal Bank of Scotland. They argue that when private sector wage growth is persistently below the inflation rate, as it is now, this will dampen consumer demand eventually bringing down inflation and further reducing the chances of interest rate hikes any time soon.

But what are the risks to a long position in the gilt market? Obviously getting in now, after a 30-year bull market for bonds can be quite hairy. But, David Morrison at GFT warns that sovereign debt issues could still creep up and spook the market: “There is a danger that people will put the spotlight on the US where there are budget problems at the state and municipal level. These problems aren’t priced in at the moment, so although de-leveraging puts downward pressure on yields, the market could see a swift reversal.”

Spread betters can still eke out profits from the bond market, but make sure you are nimble if the markets start getting antsy about debt levels.