Bond market volatility takes centre stage

18 November 2016

Last week I commented about the similarities between the post-Trump and the post-Brexit reaction of financial markets. This week I need to slightly qualify this statement. That is that we now observe some exactly opposite market movements to the immediate post‑Brexit period. The US$ has appreciated rather than depreciated and bond markets have sold off, rather than rallied. In bond markets the sell-off has spread across to other western markets and in the FX markets at least £-Sterling has also experienced a recovery. Only equity markets have continued to be relatively unfazed, with only the UK stock market experiencing slight declines, as a reaction to the strengthening of the Pound – reversing some of the upward dynamic when the currency fell. There are widespread discussions what is behind the surprising moves but I see two main strands of interpretation. The first one is that Trump’s election marks the end of fiscal austerity around the world, while Brexit only suggested that it should be on the cards. Expectation here is that not only will Trump embark on immediate aggressive fiscal stimulus through broad tax cuts akin to Ronald Reagan’s first 100 days, but that the rest of the western world will try to prevent a wider spreading of the populists’ movement with aggressive economic stimulus as well. While the longer term economic success and sustainability of such policies is not certain, there is a high likelihood that the rate of inflation would rise as governments would have to tap markets for funding. This inflation expectation is what drives up yields as investors swap bonds for more inflation safe assets. If the fiscal stimulus measures succeed in stimulating a persistent improvement in economic growth rates, then this would move inflation expectation even more back to the higher long term averages. The second strand is that bond markets are simply unwinding some of their excessive, very long term expectations of very low rates of deflation that drove up long maturity bond values so much over the course of 2016 (See the left-hand chart at the top). With the likely end of fiscal austerity on the cards such expectations simply no longer appear plausible. However, just as bond markets overshot on the upside in the summer, they are now at the risk of overshooting on the downside. After 35 years of gradual decline in government bond yields and thereby rise in bond valuations there have been many points over the past 6 years when market experts called the final inflection point or announced the onset of the ‘Great Rotation’. It didn’t happen then and I am not convinced it is happening now. There are too many structural reasons for the heightened demand for low risk government bond type assets and continued QE driven bond purchases by central banks for yields to move back up to the long term averages over the shorter term (Please note that we have dedicated the third article this week to a more detailed discussion of the different long term forces in the bond markets). It is undeniable that the bond markets are where the financial market action currently is and the resultant volatility of what has been dubbed the ‘Trump Tantrum’ is not really in the interest of investors who hold government bonds for their normally more stable values when compared to equities. To conclude, however, that the bond market move is likely to correctly predicting the imminent return of either persistently higher rates of inflation or the end of the post financial crisis era of low growth is probably just as far-fetched as was the conclusion at the beginning of the year that a global recession was imminent when stock markets sold off so markedly. For the time being I observe that Donald Trump appears to be lacking as much a concrete plan of action as the UK’s political class did after the Brexit referendum (and was just suggested still not to have in a leaked report). This brings us neatly back to the similarities and differences between the Brexit and Trump and I therefore expect the actual course of post-Trump events to be quite a lot less dramatic than bond markets may currently suggest to the discerning observer.