Turning more bullish on US Treasuries

Government bonds are typically less racy than other asset classes, such as equities. Not so this past couple of weeks, as the yields on US Treasuries – which move inversely to prices – have surged to multi-year peaks and become the focus of market attention.

The US move has dragged developed-market bond prices lower elsewhere and has had knock-on effects on other asset classes. Emerging market equities have slipped yet again, but emerging market debt has been surprisingly resilient in the face of the latest onslaught.

Most market commentators typically cite three catalysts for the yield spike:

• Strong US economic data, which suggested the Federal Reserve (Fed) may continue to tighten policy at a relatively brisk pace

• Positive remarks on the economic outlook by Jerome Powell, the Fed chair, and his colleagues

• The pending increase in US government bond supply due to the Trump tax cuts and the unwind of the Fed’s balance sheet

These are undoubtedly important, but we believe two other factors have also been at play, denting institutional and overseas demand for US government paper. The first is that a corporate tax incentive that pushed companies to shore up underfunded pensions ended mid-September. Fresh pension money should still be deployed in the bond market in the months ahead, but such tax-related demand should start to fade.

The second is that Treasuries have become far less interesting to Japanese investors on a hedged basis. Japanese investors wanting to immunise their holdings against fluctuations in the value of the US dollar have to pay a cost for doing so. That cost now stands at over 2.75%, more than offsetting the differential in yields between the two government bond markets.

However, there are a number of reasons why investors shouldn’t give up on bonds just yet:

• From a price perspective, we believe it is the best opportunity to add US duration risk in four years and the best to add UK duration in four months

• Money market futures are now pricing in a US interest rate trajectory for the next 12 months within 25 basis points of the Fed’s own outlook, indicating that policymakers and markets are unusually aligned

• The market consensus, particularly evident in buy-side surveys, has shifted again to underweight duration-sensitive assets. This means there could be sharp moves in the other direction, if investors are wrong-footed

Maybe it is time to dial the pessimism down — not up.