Has the bond rally gone too far?

There’s been a big rally in government bond markets across the world of late. Since the highs last month, 10 year yields have fallen by 36 bps in Germany and 50 bps in the US and UK. This has occurred despite hefty fiscal deficits and the switch by central banks from quantitative easing – buying up huge quantities of government bonds – to quantitative tightening which reverses the process. This results in a big increase in supply of government bonds.

The common factors behind the bond rally in the UK, US and Eurozone is falling inflation, the reality that central bank policy is on hold and the prospect that interest rates will be cut in 2024. Central banks have been quite consistent in warning markets not to expect interest rate cuts any time soon. We expect the Chairman of the US Federal Reserve and the Governor of the Bank of England to reiterate these warnings in speeches this week. This may cause a setback in the decline in yields but it should be only temporary and bond markets should continue to do well.

Let’s start with the US. The economy there has been doing well – GDP grew strongly in the third quarter. Employment has been growing with unemployment at a record low and inflation still above the 2% target, it has been easy for the Federal Reserve to argue that it will keep rates high for an extended period. Monetary policy is always a question of balancing risks: keep rates too low and you risk inflation but keep them too high and you risk recession. We think that balance of risks is about the change significantly. US unemployment may be low at 3.9% but it has risen by half a percentage point since the low in April. If that rise were to be seen on a three-month moving average basis, it would trigger the Sahm rule which has accurately indicated the timing of previous US recessions. Jobs are growing in the US, but immigration is growing even faster and with the consumer taking a bit of a breather, I expect the Sahm rule to be breached early next year.  Indeed, if unemployment edges up to 4% in data released early next month, expect the Sahm rule to feature prominently in every discussion of macro outlook for 2024.

If recession fears do grow in the US as I expect, US bonds will rally and others will follow. There are also some domestic factors at work in Europe. Wage inflation in the UK and Europe is too high to be consistent with the respective central banks’ 2% targets but most of the increases occurred in the first half of the year when inflation was high and labour markets tight. Unemployment has stopped falling in the UK and Europe and is likely to edge higher over the winter. More importantly, the rush to hire workers is over and the wage round in next spring is likely to see much lower wage awards.

There is a caveat to this run of favourable news for bonds in the UK. The Autumn statement this week is set to include tax cuts, with the promise of more to come. These tax cuts come after a massive rise in the tax burden in the UK so it’s more a question of reducing the tax increase. Nonetheless, with lower inflation, lower mortgage rates and generous social security payments feeding through, it is possible that consumer spending picks up from it current depressed levels. The Bank of England may be reluctant to join the rate cutting party until it is sure that inflation is on a path to the 2% target on a sustainable basis.

That’s a risk but overall, the downward trend in government bonds yields look likely to continue.  And that would help to support risk assets too.