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Some bond bulls break free from retreating herd

When Federal Reserve chair Janet Yellen testifies before a Senate committee on the state of the economy on Tuesday, there will be plenty tuning in who believe the epitaph for the three-decade rally in the bond market has been rightly written.

US president Donald Trump’s plan to ramp up government spending and axe corporate taxes threatens to accelerate inflation, push up interest rates and widen the deficit — a potentially toxic combination for debt markets.

Yet some fixed income bulls remain undeterred, betting that bond yields will actually fall. Whatever Ms Yellen says in her testimony, a small band of analysts and fund managers are convinced that the market consensus is wrong. Equity markets will turn more turbulent, they believe, and bond yields will tumble again rather than climb back to more historically normal levels.

“There’s a lot of policy uncertainty out there, and our belief is that there’s been too much belief in this,” says Michael Lillard, head of PGIM’s $681bn fixed income business. “We’ll see some fiscal stimulus, some pro-growth tax policies, but is that really going to change the growth potential of the US? We don’t think so.”

Some doubts have begun to sneak into markets this year.

The post-election bond rout has paused lately, with the 10-year Treasury yield edging back from a peak of 2.6 per cent in mid-December to 2.43 per cent today. The $42.2bn AGG exchange-traded bond fund that tracks the biggest US fixed income index has moved up 1.2 per cent since its December low, and LQD, its $29.5bn investment-grade corporate bond equivalent, has nudged 1.7 per cent higher over the same period.

“Some markets had taken the present value of all the potential positive things [about President Trump’s policies] and factored them in, but none of the negative things,” observes David Hoag, a bond fund manager at Capital Group.

Those questioning the new, gloomy consensus for bonds remain in the minority. The average estimate of strategists polled by Bloomberg is for the 10-year Treasury yield — the world’s most influential bond rate — to rise gently but firmly to almost 2.8 per cent by the end of the year, and to touch the 3 per cent mark that it reached at the peak of the 2013 “taper tantrum” before the middle of 2018.

“The worst is yet to come,” analysts at Société Générale said recently, predicting a “big hangover” for the sovereign bond market after the multiyear rally that depressed yields to record lows.

The most relevant historical parallel for markets is the 1950-1981 period, they say, when the 10-year Treasury yield rocketed from under 2 per cent to over 15 per cent. “Our concerns also lie in valuations and, as market participants progressively realise that they remain dangerously rich, in the potential unwinding of the record exposure to the rates risk,” SocGen analysts argue.

Bill Gross, the former Pimco founder now at Janus Capital, is also worried that the bond market could swoon further, especially if the Bank of Japan and the European Central Bank stop their own quantitative easing programmes.

“I would venture a guess that without quantitative easing from the ECB and BoJ that 10-year US Treasuries would rather quickly rise to 3.5 per cent and the US economy would sink into recession,” he warned.

While few are as pessimistic as Mr Gross and SocGen’s top strategists, the consensus view remains that the bond market will continue to be under sustained pressure. Of the 61 analysts polled by Bloomberg, almost a third think the 10-year Treasury yield will end the year at 3 per cent or higher. Only six reckon it will fall from its current level.

But some with credibility are swimming against the tide. Steven Major, global head of fixed income research at HSBC, is one of the leading proponents of an alternative view of where the bond market is heading. The 10-year Treasury yield will fall sharply to test new lows and end 2017 at 1.35 per cent, he predicts.

In October 2015, when the Treasury yield was about 2 per cent, Mr Major was among the few who forecast the rally that would dominate the first half of 2016.

Mr Major argues that other analysts predict higher bond yields because of a series of “myths”, such as inflation and economic growth mattering longer term to bond yields, or that higher budget deficits lead to rising borrowing costs. “Our view is for lower yields by year-end and this is because we do not buy the arguments that do not fit with the empirical facts,” he says.

This meshes with Mr Lillard’s views, too. Although he reckons the 10-year Treasury yield might only fall to 2.25 per cent by the end of the year, he doubts that the Fed will be able to raise interest rates much before the economy stalls again, burnishing demand for more defensive bonds like Treasuries.

“We’ve been very aggressive on risk, but we’re taking chips off the table now,” he says. That means paring back PGIM’s positions in junk bonds and seeking more safety in higher-rated debt. “We think the Fed is determined to raise rates, but as they raise rates something is going to break.”

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