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Return of the bond vigilantes

1 Mar 2021

Financial markets are facing a paradox: a more upbeat economic outlook has sparked a bond sell-off, but could it spread to other asset classes.

This year had a turbulent start with supporters of former US president Donald Trump storming the US Capitol in an unsuccessful attempt to prevent the handover of power to Joe Biden. But they were not the only vigilantes making a comeback in the US, as bond vigilantes sparked a sell-off across developed market debt, causing yields to surge.

Investors started dumping bonds due to a combination of progress on Covid vaccines and the prospect of stimulus packages, which sparked fears of rising price levels, despite inflation being within the 2% target.

Since the start of the year, yields on 10-year US treasuries have risen to 1.46% from 0.93%, while yields for 30-year bonds have climbed to 2.24% (see chart). Real yields on 30-year US government debt, adjusted for inflation, left negative territory for the first time in 12 months, gradually climbing to 0.26. The sell-off is reminiscent of episodes in the early 1990s when fixed income investors pushed US yields from 5% to above 8%, or the run on eurozone debt during the 2009 debt crisis.

This latest rise in yields presents a double-edged sword for pension funds, who might face much needed relief in the calculation of their liabilities, but also the risk of knock-on effects for investment returns across other asset classes.

A reason why many investors continue buying equities despite stretched valuations is that compared to negative yielding bonds, they offer good value.

This could change if yields continued to rise. The run on bonds is having repercussions across stock markets, with the S&P500 falling by 2.45% as of 25 February, and the tech heavy Nasdaq dropping by more than 3%.

While in the case of the storming of the US Capitol, matters were settled by the US Justice Department, investors will be watching closely whether central bankers would take on their role as sheriff of fixed income markets.

Central bankers are so far dividend in how to respond to the challenges. While the ECB’s Christine Lagarde has expressed concern about the sell-off and announced plans to step up bond market interventions, Fed chair Jerome Powell opted to play down inflation concerns and interpreted rising yields as signs of an improved growth outlook.

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