Government bonds likely to benefit less from ‘safe haven’ inflows going forward due to worries over valuation and volatility, says DNB Markets

While the bond market rally is expected to resume as global growth weakens and trade tensions continue to build, government bonds could benefit less from ‘safe haven’ inflows going forward, due to worries over valuation and volatility, according to the latest research report from DNB Markets.

The environment of low and negative yields has changed the way some investors trade government bonds. This change, along with the asset purchases by central banks, has made their valuations de-couple from underlying economic fundamentals, which in turn has made them more volatile.

Increased volatility and fears of overvaluation make government bonds less attractive as safe investments, something the sell-off of the last two weeks underscores.

Last week, sovereign bonds in the US and Europe had their sharpest weekly sell-off since after Donald Trump’s election victory in November 2016. The yields on 10-year US Treasury notes rose 0.34 percentage point (34bp), while equivalent yields in Germany rose 18bp.

Despite the outsized moves, this change returned yields only to the levels from the beginning of August, which was when the bond rally picked up pace due to the escalation of the US-China trade war, the report added.

Indeed, while last week’s bond sell-off was the strongest in almost three years, it follows the sharpest rally in almost a decade. From November 2018 until Wednesday two weeks ago, 10-year yields in the US had fallen by 1.8 percentage points.

This corresponded to a 20 percentage rally in 10-year US Treasury notes during the course of just 10 months, which constitutes the strongest (i.e largest and fastest) such move since the height of the eurozone debt crisis in 2011.

Additionally, investors remain hopeful of a de-escalation of the US-China trade war, and such hopes have gained traction as the two sides have toned down their rhetoric recently. As Beijing first said it would not retaliate against the most recent tariff increase by the US, the US responded last week by delaying some of the tariffs on China.

"We believe fiscal policy will play a larger role in stimulating the economy in the years to come, but we also believe continued loose monetary policy is a prerequisite for this. Thus, the notion that “monetary policy has played its part” is wrong, in our view. We believe the ECB will eventually make changes to its issuer limit restrictions to allow itself to conduct QE at least through next year, and if anything for as long as necessary. Furthermore, we believe the market has gone a bit too far in pricing out further rate cuts by the Federal Reserve (Fed) in the US. We expect the Fed to cut interest rates at its upcoming meeting this week, and then again in December and March, which is slightly more than markets are currently pricing in for the same period. This should add to pressure on long-term yield in the coming months," DNB Markets further commented in the report.