Twice this year, in February and a couple of weeks ago, US bonds were sold off aggressively.
On both occasions, the yield (or interest rate paid) on a US bond with 10 years to maturity increased by about four-tenths of a percentage point, taking it from 2.4 per cent in January to 3.25 per cent last week.
In days gone by, sharp increases in US bond rates were generally followed by higher bond yields in other countries, particularly Australia, and at times as well by a marked fall in share prices in the US and around the world. We saw some evidence of that effect late last week when the US sharemarkets lost 5 per cent in two sessions.
But in 2018 the yield on long-dated Australian bonds has mainly moved sideways, ignoring the US lead. Our 10-year yield was 2.65 per cent in early January and 2.75 per cent last week —; it’s gone from being a quarter of a percentage point above its US equivalent when the year began to almost half a percentage point below the US yield. The fall in the Australian dollar against the US dollar this year, despite our strong commodity prices, owes a lot to this big swing in relative interest rates.
In my view, we can expect US bond yields to increase further in coming months. Bond yields in other countries could well rise, but by less than those on US bonds. In these times, bond investors can find some protection against capital losses by holding shorter-dated bonds and inflation-linked bonds. And equity investors can prepare for opportunities to buy quality shares at attractive prices.
The causes of higher yields
A range of influences has been pushing US bond rates higher, in absolute terms and relative to bond yields in other developed counties, including recent hikes in the US cash rate, the shrinking of the Fed’s balance sheet now it’s ended quantitative easing strong growth and a tightening labour market in the US, the upward creep in inflation, and concerns about funding the huge increase in the US budget deficit (forecast to rise to 5 per cent of GDP).
Because bond yields and the market prices of bonds move in opposite directions, increases in yields have been costly for investors in US bonds.
Some investors are taking the view that, with US bonds noticeably cheaper, it’s now a good time to be stocking up again to be buying long-dated US bonds. But many are concerned that US bond yields will move higher and have switched (or are planning to switch) a part of their holding of US longer-dated bonds to bonds with early maturities (which carry a lower yield but have lesser price falls when yields move).
US longer-term yields have recently increased relative to shorter-dated yields. The US yield curve has steepened suggesting, if history is a reliable guide, that risks of an early US recession have reduced. And, rather surprisingly, the “spreads” between the yields on government bonds and yields on corporate bonds have, so far, remained quite narrow.
Many commentators predict the sharp rises in US bond yields will lead to a big drop in share prices, even to the beginning of a bear market in shares in the US and around the world. Their concerns relate to the higher bond yields slowing growth in the US economy and that the higher discount rates to be applied on future corporate earnings would lessen the appeal of shares.
Following the bond yields rise in February, average US share prices sold off by almost 10 per cent. They soon recouped a good part of early losses. Most other sharemarkets, including ours, reacted calmly to both the February surge in US bond yields and to the initial sell-off in US shares and outperformed US shares in the June quarter. But US shares did well in the three months to the end of September, as average profits of companies surged because of the strong economy and the tax cuts. Last week we saw the US markets get volatile again. Keep an eye on those bond yields!
Don Stammer is an adviser to Altius Asset Management and Stanford Brown Financial Advisers. The views expressed are his alone.