Discover the forces driving the rise in global bond yields

Global bond yields rose significantly in November, reportedly as a result of an improving global growth outlook leading to inflation, and a broad multi-regional turn away from fiscal austerity, leading to increased government deficits. So what is driving this rise?

Expectations for US Federal Reserve (Fed) fund rate increases have grown markedly post-election

This reflects the expectation of a hike in rates by the Fed in December and factors in one or two rises in the new year (up from one hike this year and a 50 per cent chance for one next year) as expansionary fiscal policy reduces reliance on monetary policy. The US 10-year bond yield has risen to 2.4 per cent up from its all time low in July of 1.4 per cent.

Australian expectations for the cash rate are much more muted with the majority expecting the Reserve Bank of Australia (RBA) to be on hold for many months and some even predicting further falls. It is interesting to note in context that our 10-year Commonwealth Government bond yield has risen to 2.8 per cent from 1.8 per cent, which was the all time low in August.

There are broadly two camps positioning in response to these rises in yields

The first camp is of the view that this is the beginning of the ‘Great Rotation’ – a phrase coined by Bank of America Merrill Lynch in 2011 and the subject of many false start calls. It suggests that global investment funds will at some stage ‘rotate’ billions out of the bond market and into the equity market, ending the three-decade bull market in bonds and fuelling a broad stock market boom. This group is bullish on stocks and supportive of the move out of ‘bond proxies’ (for example, utilities and telcos) into cyclicals (for example, industrials and commodities).

The alternative camp believes that despite Donald Trump’s election and a rally in commodity prices (among many other things), nothing has fundamentally changed. We are still in a world with higher debt levels than those that triggered the global financial crisis, with the forces of disinflation firmly in place and unhelpful developed market demographics. They see the move in yields and inflation as a cyclical move within a much broader secular trend that is showing no sign of abating.

In assessing these arguments, it is important to consider changes in bond yields in a longer term context. While the 10-year Australian government bond yield has increased over 50 per cent from its recent lows, over the last three and a half decades the rate fell from 16 per cent to a low of 1.8 per cent. The one percent increase in yield is less dramatic when viewed in this context.

The path of rates and the likely market impacts vary depending which camp you are in

The path of rates from here then is up if you align with the first camp – the long trend down from 16 per cent turns and begins a path upwards. Rates will rise as the world continues to recover, bond markets price in higher growth and therefore higher inflation – a ‘V-shaped path’ of higher global growth leading to higher earnings and the rotation into equities continuing to push equity markets higher.

Alternatively, if you’re in the second camp, the trend will be sideways and volatile. This ‘L−shaped path’ fits with a more troubled world view: persistent low growth, widening income disparities and increasing drag from demographic changes. In this world, the current ‘cyclical’ moves in rates and inflation should be followed closely as they will lead to opportunities to buy assets at relatively attractive levels before the trend reasserts. Examples of likely assets would be those above-mentioned ‘bond proxies’.

Our view is to hope for the first scenario but plan for the second

A diversified portfolio holding a balance of real assets, cash and some selected value equity exposure will still perform well in the first world, but will be defensive in the more difficult world. A portfolio positioned to take advantage of the ‘great rotation’ will perform better in the first instance but is much more likely to suffer heavy capital losses if the secular forces reassert themselves and markets reprice. This view is emphasised when we consider equity valuations – at current valuations markets are pricing in many of the positives, including high growth in earnings and low risk free rates for valuations, two elements that are to an extent inconsistent.

This insight may contain general financial advice and was prepared without taking into account your objectives, financial situation or needs. Before acting on any advice, you should consider whether the advice is appropriate to you. Seeking professional personal advice is always highly recommended. Any forward looking statements are based on current expectations at the time of writing. No assurance can be given that such expectations will prove to be correct.

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Patrick Broughton

Investment Committee Member

Patrick has 32 years of investment banking experience spanning over a broad range of financial markets, including equities, fixed income, hybrids and convertibles and foreign exchange.

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