Are bond markets about to fall over the cliff edge? william bourne thinks not yet

One of my themes over the past year has been the remarkable lack of volatility in currency, equity and bond markets.  I have tended to ascribe it to QE: there is always a cash-rich buyer to buy into a dip.  

 

In 2018 we have seen a rise in bond yields but, to my mind, it is pretty clear that this is simply normalisation as a term premia (ie. the return premium investors require to accept duration risk) rise from the exceptionally low levels of the last two years.  At 2.85% the US ten-year bond yield may be the highest level in six years (with one small exception in 2013) but it is still a lot lower than it has been through much of its history. 

 

This week equities have reacted by falling sharply.  Again, I would consider this as being both healthy and normal: it is a reminder to investors that markets go down as well as up and promotes healthier investment decisions.  

 

The big question today, of course, is what happens next.  Will bond and equity markets continue to fall or will buyers come in at lower levels as they have in the past?

 

On the one hand the market’s inflation expectations have clearly risen, partly because of the signals given by the US Federal Reserve.  Our friends at CrossBorder Capital suggest from their analysis that a 2.5% inflation level is the inflection point at which higher inflation begins to reduce equity market valuations.  The medium is a higher discount rate reducing the value of their future earnings stream.

 

We are not quite there yet: 10 year break-even on US TIPS is currently 2.0%.  But we will be keeping a beady eye on this metric in particular.

 

So, are markets heading over a cliff?  In the absence of a geo-political event, we doubt it at the moment, though the risks are clearly rising.  Inflation is still benign, investors are still cash-rich and bond markets are still in the process of normalising.

 

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