Bond markets start to look vulnerable

The recent sell-off in bond markets has received quite a deal of coverage in recent days with a particular focus on the decline in the price of UK gilts, prompting some speculation that some overseas investors are losing confidence in UK government debt.

The recent sell-off in bond markets has received quite a deal of coverage in recent days with a particular focus on the decline in the price of UK gilts, prompting some speculation that some overseas investors are losing confidence in UK government debt.

While that might seem a plausible argument it completely ignores the fact that US treasuries and German bunds have been falling quite heavily as well. We also know that overseas investors have maintained their appetite for UK government debt given that the most recent data showed a net inflow from overseas investors in October.

Furthermore if there was a loss of faith in UK government debt then the decline in prices would surely be confined to UK gilts. The fact that it isn’t suggests that some people are adding two and two and arriving at five.

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One of the main reasons we are seeing this decline in bond markets is largely down to the fact that we’ve seen a decent improvement in US, German and UK economic data in recent days which in turn has shifted market expectations away from the likelihood that central banks will ease policy further, particularly given that the embers of inflation are starting to flicker, not only in the UK but elsewhere as well.

In recent weeks we’ve seen inflation numbers hit their highest levels in two years in the UK, EU and the US, with particularly strong rises in the UK, as a result of the fall in the pound, but we’ve also seen rises in countries like Spain and Germany.

While some of this may be down to the effect of lower energy prices finally working their way out of the numbers the fact remains that forward inflation expectations are rising well above the level of current 10 year yield levels. The latest manufacturing PMI data from the UK showed that prices rose at their fastest rate since 2011.

This makes government bonds at current levels not only expensive but loss making, after all if forward UK inflation expectations are at 2.5% and UK 10 year yields are at 1.2% then it doesn’t take a genius to work out that you are losing money in real terms, and that bonds are overpriced.

These rising inflation expectations also make it much less likely that central banks will have the scope to ease policy further in the coming weeks, and in the UK’s example makes it highly unlikely that we’ll see another rate cut from the Bank of England this week, when they also publish their latest quarterly inflation report, when we can expect to see the bank raise its inflation forecasts.

Bank of England MPC members have been keen to stress that they will look past any rise in inflationary pressures in the coming months which probably means they won’t raise rates to counter a rise in prices, but it could well constrain their ability to cut rates further, and that is an important distinction.

Bond markets appear to be pricing on the prospect of higher inflation which in turn given current yield levels makes them vulnerable to a sell-off, and this could well play out in the coming weeks.

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