Regime Change in Bond Markets?

With a steady repricing of global bond markets having contributed to a sharp plunge in global stock markets, there could be a whiff of a new era in the air. Given the failure of both markets and central banks to forecast inflation accurately, we should all be humble about the level of precision attached to the timing or nature of the bond market’s next chapter. What we can say is that any such shift will likely be cyclical rather than secular.

After a material repricing of 10-year U.S. Treasuries since September 2017, four factors argue against an imminent regime change in major global bond markets.

First, market pricing of policy rate expectations appears reasonable in the context of a mature U.S. growth cycle and a gradually normalizing inflation environment. The U.S. futures market is now pricing roughly four additional rate hikes through January 2020. This is the first time since the Federal Reserve began publishing its “dot plot” (a projection of where it expects the policy rate will be in the long run) that market pricing has caught up with the Fed.

Second, global bond markets have become increasingly integrated – a spillover effect from post-crisis unconventional monetary policy across major central banks. The Bank of Japan (BOJ) and the European Central Bank (ECB), for example, have reiterated their commitment to loose monetary policies for the time being. Japanese and European overseas bond purchases could well constrain the cyclical repricing of other advanced economy bond yields.

Third, the effects of past quantitative easing matter. Central banks have removed large amounts of duration and convexity from the hands of private market participants. The stockpile of bonds held by these central banks is like a wet blanket thrown over past and potential sources of volatility.

Finally, the equity market correction seems to be a reaction to the lofty exuberance that followed U.S. tax reform and the remarkable strength of global growth. The reining in of extreme equity valuations likely will not stop bond yields from repricing gradually higher in line with the cyclical recovery, and in fact reduces the likelihood that the repricing becomes disorderly (thereby undermining an already mature recovery).