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Bond wobbles

John Redwood, Charles Stanley’s chief global strategist, asks whether government bonds represent a good investment.

John Redwood

in Features


We have been saying for some time that government bonds may not make good investments in current conditions. In the last few days there has been a bit of a selloff in the government bond market. As a result the yields available on US Treasuries, euro denominated bonds and even Japanese bonds have risen a bit.

If we take the 10 year cost of borrowing for governments, the US government now has to pay 2.55%, the German government 0.52% and the Japanese government a tiny 0.07%. Other advanced countries have low rates as well. These rates are still very low by historical standards. They mean that after allowing for inflation in most cases save the US there is a negative running return. Without a capital gain on the bond the owner will lose money in real terms from the holding.

The rates have been pushed to very low levels by the deliberate policies of the Central Banks. Only the US has moved on from creating new money to buy up bonds to depress the interest rates. The US is now in the business of raising its official short term interest rate, and gradually reducing the volume of bonds the Fed owns. The UK’s Bank of England is no longer expanding the portfolio of bonds it owns, but it is still buying replacement bonds with money from bond repayments. The European Central Bank (ECB) is reducing the amount of additional money it creates to buy up bonds. The Japanese Central Bank has a target of keeping its ten year interest rate at zero, which means it has to buy a variable amount of additional bonds to try to keep the rate down.

So why has the market recently pushed up the rates a bit? It’s a response both to growing beliefs that the world economy will enjoy a faster synchronised recovery than forecasters thought last year, and a reaction to the words and actions of the central banks. Markets are hyper sensitive to what the central banks say and do, as they are well aware of how important central bank intervention has been in pushing up bond prices in the first place. As more people become optimistic about the pace of growth, so more ask themselves when will the central banks reduce their stimulus or cancel their special measures?

Against this background the Bank of Japan has reported that instead of spending 80 trillion yen on buying bonds last year they only bought 58 trillion. They also appear to have cut their recent purchases of additional bonds by a modest amount. This was enough to make some fear an end to the large amounts of cash the Japanese authorities are putting into the global system. It seems unlikely, however, that the Bank of Japan will want to put up interest rates or will wish to take any action that could impede the better recovery now underway in Japan. There is still little likelihood of Japanese inflation getting up to the 2% target. If Japan can keep rates on the floor whilst buying fewer bonds it will do so, but this does mean an end to easy money in Japan.

There is also speculation about the future policy of the European Central Bank. Whilst no-one thinks we are about to see official rate rises in the Euro area, there is general agreement that the ECB will cut the amount of new money created to buy bonds progressively this year until it has ended additional quantitative easing. That of itself should not undermine what is now a decent recovery in the Eurozone economy. There is however, the issue of who will replace Mr Draghi when he leaves the job of Central Bank Governor in October 2019. Were a German candidate to gain the job there could be a move to a tougher stance. The Bundesbank is unhappy about the continued scale of Quantitative easing bond purchases and the very low interest rates, when the German economy is running strongly and is beginning to see some inflation. This is more a worry for the future.

In the US markets have come to trust Janet Yellen who has given plenty of advance warning of changes. They will have to get used to Jerome Powell who takes over next month as Fed Chairman following ratification. If anything he would be expected to be a bit more dovish, as he is probably in sympathy with the President’s strategy of economic expansion with some banking deregulation to ease credit. This week there were unconfirmed rumours that China might reduce its purchases of US bonds at a time of possible trade tensions with the Trump administration.

All in all we expect a modest rise in bond yields this year and have just seen some of it. We do not expect a big bond sell off which could spill over to sour equities as well.

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

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