Bond markets have been jolted by central bank signals that interest rate rises are drawing closer, sparking the steepest price declines since a global debt slide at the start of the year.
Investors have dumped government bonds in the wake of the latest policy meetings at the US Federal Reserve and the Bank of England last week, at which both indicated a willingness to respond to growing inflationary pressures by lifting short-term borrowing costs.
At the same time, a surge in energy prices in Europe — and particularly the UK — has added to fund managers’ conviction that the jump in inflation will last longer than central bankers previously expected.
“Central banks have been trying to convince us that inflation is transitory,” said Dickie Hodges, a bond fund manager at Nomura Asset Management who has been betting against US Treasuries. “Given the circumstances I think they’ve been in denial — if you can show me one thing that’s cheaper today than it was before the pandemic I’d be surprised. So I think a reassessment has been overdue.”
The bond market initially barely responded to news last Wednesday that a growing number of Fed officials expect rates to rise next year, as the US central bank said it could “easily move ahead” with plans to wind down its bond buying as soon as November.
But a more pronounced hawkish shift from the BoE the following day — with the UK central bank signalling a rise could arrive before the end of the year — sparked a wave of selling that quickly spread through global markets and has continued this week, pushing yields sharply higher.
“Sustainable moves higher in Treasury yields are typically more globally oriented. We don’t see it as a coincidence that the hawkish Bank of England meeting coincided with this move higher in rates,” said Kelsey Berro, fixed income portfolio manager at JPMorgan Asset Management.
On Tuesday the 10-year US Treasury yield, a benchmark for financial assets around the world, climbed to 1.55 per cent, the highest level since June and a steep rise from 1.31 per cent a week earlier.
Moves in the UK have been more sharp, with 10-year gilt yields rising above 1 per cent for the first time since March last year, more than doubling from the levels recoded in late August. Even the eurozone, where higher interest rates are a more distant prospect, has not been spared. The 10-year German Bund yield rose on Tuesday to a three-month high of minus 0.17 per cent.
The accompanying decline in bond prices means the Barclays Global Aggregate bond index — a broad gauge of corporate and government debt around the world — is down about 1.6 per cent in September, its biggest decline since March.
Trend-following “commodity trading adviser” hedge funds sold roughly $81bn of Treasury holdings in the past week as they took bets against the market, according to Citi analysts. After months of net long positions in interest rates globally, positioning is now short.
Investors and analysts said the BoE in particular has cleared the way for a revival of this so-called “reflation trade”.
“We’ve gone through most of this year thinking the BoE would raise rates earlier than markets thought, and ahead of the Fed,” said Sandra Holdsworth, head of rates for the UK at Aegon Asset Management. Even so, the BoE’s assertion last week that rates could rise before its bond-buying programme runs out at the end of the year was a “big surprise”, she said.
In a speech on Monday evening, BoE governor Andrew Bailey made no attempt to push back against market expectations of a rate rise by February, sparking a fresh wave of selling. An increase to 0.25 per cent by December is viewed as a coin toss by futures markets.
Unless a further wave of the virus prompts renewed shutdowns, or the end of the government’s furlough scheme disrupts growth, even a rise in November is possible, Holdsworth thinks.
In Europe the debt sell-off has been driven partly by a rise in expectations for long-term inflation, which erodes the fixed interest payments offered by bonds.
A closely watched gauge of retail price inflation expectations during the second half of the next decade has climbed to 3.85 per cent in the UK, the highest in 12 years. The equivalent measure for eurozone consumer prices is at a six-year high of 1.81 per cent.
The Fed’s expectations of US inflation have also been rising. In the statement following last week’s meeting, Fed officials saw core inflation at 3.7 per cent in 2021, up from its estimate of 3 per cent in June. Next year the Fed sees inflation at 2.3 per cent, against its previous estimate of 2.1 per cent. Chair Jay Powell in remarks to Congress on Tuesday said that inflation could stay higher for longer, particularly if supply chain issues persist.
Inflation expectations in Europe, the UK and the US may continue to rise with energy prices. Brent crude, the global oil benchmark, on Tuesday rose above $80 a barrel for the first time in more than three years. Other commodities including coal, carbon and European gas prices all hit record highs.
“The dominant driver of long dated global bond yields seems to simply be the growing energy crisis,” said Mike Riddell, a portfolio manager at Allianz Global Investors.
“It’s not immediately logical because the energy crisis is likely to be a short- to medium-term supply shock, and shouldn’t result in structurally higher central bank interest rates. But the surge in gas prices is creating longer term inflation uncertainty, where this additional risk premium is being built into [bond yields].”