21 November 2016
Over the past week Australian shares were 0.2% higher. Shares in developed countries were unchanged with the US market up 0.8%. Shares in emerging markets lost 0.5%. The Australian dollar was 2.8% lower at 73.38 US cents. The 10 year bond yield in Australia was 0.15% higher at 2.72% while in the US, the 10 year bond yield closed the week 0.20% higher at 2.35%. The oil price gained 5.3% to 45.69 US dollars per barrel.
Share markets didn’t fall as many predicted following the Trump election win, highlighting the difficulty of short term market timing. However, bond markets around the world have experienced a sell-off, by some measures the largest two week sell-off in over 20 years. It’s important to understand why this has occurred and assess whether it signals any economic / market scenario that we should consider.
Remember that when bond yields rise, the price of bonds falls. So why do bond yields rise? There are three main reasons:
- Concern around the credit quality of the issuer.
- Unwinding of what’s known as the ’safe haven trade’. In periods of heightened volatility and uncertainty investors sometimes flock to the perceived safety of bonds bringing the yield down. As this uncertainty abates investors move out of bonds and yields rise back to a higher level.
- Speculation regarding higher future short term interest rates, potentially due to an increase in inflation expectations.
So what most likely explains the current sell off in bonds? Probably not the first point as little has changed recently regarding the creditworthiness of most governments. The recent sell-off is probably a combination of the second and third points. The bond yields of many countries were at extremely low levels, even negative. So perhaps the degree of fear which led to these levels has unwound a little. Additionally, some of Trump’s policies could accelerate economic growth which could allow the Federal Reserve to increase interest rates. Other policies, such as trade policy, could lead to increased inflation, making bonds less attractive.
These market events flow into our long term asset allocation work. We consider what is the longer term outlook for inflation, bonds, and other markets. For example, if bond yields are higher, share markets could fall a little. These considerations then flow into the portfolios we construct for our members.