How far will the bond back-up run?

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The entire pet shop is squawking the end of the bond bull market. The latest is Phil Baker:

When I first started writing this column for AFR Smart Investor in 2004, the yield on the benchmark 10-year government bond was trading at about 5.12 per cent and investors complained that it was way too low.

…It’s been a great run for bond fund managers, thanks mainly to those falling yields, but it is now tricky for professional players to eke out a decent return. These are once again tough times for fixed-interest investors, with mixed signals from fixed-interest or income-producing investments in the world’s bond markets.

In hindsight, it’s been a golden age for fixed-interest investors, who have cashed in for almost 30 years as global central banks did nothing but cut rates. Those days look to be over. There’s always a signature deal to mark any sort of turning point, and the recent 30-year bond deal in Australia might prove to be the latest one.

…Remember, the higher the interest rate, the lower the present value. So, for example, $100, to be received in 10 years’ time, discounted to today using a 2 per cent rate, is worth $82.03. When the discount rate is raised to 10 per cent, that same $100 in 10 years is worth only $38.55.

When government bond yields rise, so will the discount rate. For the past 30 years it’s been the other way around. Now, however, that’s about to change.

Meh. The secular bond bull market may or may not be over. But there’s no bear market starting, either way. The conditions for global deflation are still overwhelmingly dominant in peak debt, free-moving capital and labour, technology and fading demographics.

The de-globalisation revolution has just started and will take many years to unravel it all. What’s more, it is very likely to result in huge and hugely deflationary global shocks along the way, such as the disintegration of the euro and China’s downshift to slower and less commodity intensive growth, whatever path that takes.

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More importantly, for local investors, Australia’s economic and inflation outlook remains poor as:

  • the dwelling construction boom peaks;
  • the car industry departs;
  • the bulk boomlet busts and mining capex keeps falling;
  • fiscal consolidation remains a priority, and
  • immigration falls away owing to political imperatives.

What we are currently experiencing is cyclical pull forward in inflation thanks to Trump stimulus. That might be given greater impetus by others doing the same. But as things stand, US stimulus is going to have serious deflationary impacts in emerging markets as the US dollar rips higher. Once the present bulk boomlet busts we’ll see US wages vying with a resumption of commodity and tradable deflation, quite possibly including oil, and the end result will not be tearaway inflation there either.

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So, how far does the bond back-up run? It’s certainly running hard now:

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And I would not, perhaps, expect to see it stop until some kind of disruption occurs going the other way. Those events might include:

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  • the Italian referendum or any one of the European elections next year;
  • a rampant USD blowing EMs apart too fast;
  • Trump doing something upsetting like Chinese tariffs, or
  • China slowing in H1 2017 and bursting the bulk bubble.

Before then, yields have room to rise a lot further without disrupting the downtrend:

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It’s always a challenge to know when to buy but not yet!

About the author
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal. He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.