Should investors jump back on the “reflation” train?
That’s a question many have started to ask as two major sources of uncertainty which have long kept investors on edge in 2019 appear to be clearing away this week, smoothing the runway towards higher long-term government bond yields next year.
With a U.S. - China phase one trade deal agreed and the U.K. Conservative Party sweeping to a landslide victory, the geopolitical headwinds may be fading, meaning demand for safe haven long-term government bonds may wane also.
“We are beginning to chip away at the fear-inducing issues. Brexit is no longer a big confidence crusher, and trade is slowly going away as a worry,” said Michael Kelly, global head of multi-asset for PineBridge Investments.
See: Phase 1 of U.S.-China talks was hard — and the next part will be even harder
Key to a bond-market selloff and rising yields in the new year is the detail and enforcement of the phase one trade agreement this week between the U.S. and China, though at least for now the world’s two largest economic powers are both looking to avoid a further escalation in tensions. That could help restart global capital investment spending, a boon for stocks and a danger for bonds, wrote Dario Perkins, head of global macro strategy at TS Lombard.
Gregory Faranello, head of U.S. rates at AmeriVet Securities, said the benchmark U.S. Treasury 10-year yield could settle into a higher trading range between 1.75% and 2.25%, slightly higher than the recent range in the last few months of 1.50% to 2.00%. A combination of accommodative financial conditions supporting economic growth around the world, thanks to recent central bank policies, may provide the bearish impetus.
At the same time, the Federal Reserve’s willingness to keep its policy interest rate steady well into 2020 and a steadily slowing U.S. economy have led some strategists to call for the 10-year Treasury yield TMUBMUSD10Y, +0.00% to stay range-bound. The benchmark maturity closed at 1.82% on Friday.
Fed Chairman Jerome Powell raised the bar for an interest-rate increase last Wednesday, arguing that it would take a sustained and significant increase in inflation for a policy change. That appears to be a tall task as the Fed’s preferred measure of inflation, core personal consumption expenditures, grew year-over-year by 1.6% in October, running below the central bank’s 2% inflation target.
It’s no wonder that Rick Rieder, global chief investment officer of fixed income at BlackRock, foresees the 10-year yield hanging around 1.80%, near current levels. Neither expecting a boom nor recession, he said the benchmark yield had little reason to make outsized moves.
Yet Ed Al-Hussainy of Columbia Threadneedle says the widespread belief that bond yields will stay range-bound is a “bunch of garbage,” and that history showed that long-term yields ended up being more volatile than expected, with the benchmark bond yield often seeing shifts in the vicinity of a 100 basis points in each of the last few years.
Al-Hussainy conceded though that it was difficult to imagine a repeat of this year, when the 10-year note yield from peak to trough fell around 1.20 percentage points and briefly threatened to establish a new all-time low, last set in June 2016 at 1.35%.
Persistent fears that the U.S. economy would eventually succumb to global growth headwinds and suffer its first recession since 2007-2009 led to a buildup of bullish sentiment in Treasurys and doubts whether stocks could continue to ring in new records.
The sharp slide in yields helped favor both stocks and bonds this year, and the Fed’s three rate cuts helped stimulate financial conditions and keep the economy growing at an even keel. The S&P 500 SPX, +0.01% is up 26.4% year-to-date as a result, albeit after suffering a brutal pullback in December 2018.
Year-to-date, $789 billion has poured into bond mutual funds and exchange-traded funds, as $203 billion left stock-market funds, according to data from the Investment Company Institute.
If investors start to feel more confident in the economy’s resilience again in the new year, funds could flow back into equities and out of bonds.
However, even PineBridge Investments’, Michael Kelly, said it was difficult to envision a mauling of the bond bulls, which have been consistently rewarded throughout the last three decades for their willingness to hold debt securities that have offered ever-dwindling yields.
Forecasters have historically drawn out a consistently upward trajectory for economic growth, interest rates and thus Treasury yields, only to find they were wrong time and time again. The three decade long bull run has frustrated speculators as inflation and growth have steadily dwindled.
Read: ‘Phase 1’ of U.S.-China trade deal cuts some tariffs, eliminates new ones planned for Sunday
Looking ahead for next week, investors will see U.S. purchasing managers indexes for both the manufacturing and service sectors, industrial production data, existing home sales, and personal consumption expenditure numbers.
See: Economic Calendar
Investors will also see a trickle of earnings reports in the last week before the Christmas holidays, with Fedex FDX, +0.47% , Micron Technology MU, +0.45% , General Mills GIS, -0.12% and Nike NKE, +0.05% all set to report results next week.