Volatility in government bond markets has risen sharply following Ben Bernanke’s May testimony. Having fallen as low as 1.6 per cent as recently as May, 10-year US government bonds are now trading at roughly 2.2 per cent, levels not seen since the first half of 2012.
This is not the first government bond selloff in 2013 but, critically, the drivers of this selloff are different to those at the start of the year when we saw 10-year US government bonds top out at just above 2 per cent in March.
At the beginning of the year, the market’s confidence in the global recovery was reasonably strong and government bonds reflected this through increases in the level of expected inflation. This is measured by the so-called ‘breakeven yield’ – the difference between the yields of nominal and inflation-linked government bonds – which rose to roughly 2.6 per cent by March.
Today, while government yields are again on the rise, the level of inflation implied by the US market has actually dropped to just above 2 per cent. This is because we have seen a sharp correction in inflation-linked bonds whose yields have risen much faster than those on nominal government bonds. For the first time since 2011, 10-year inflation-linked bonds in the US now command a positive real yield.
While the outcome appears to be the same – higher government bond yields – it is clear the underlying drivers are not.
Until Mr Bernanke’s comments, bond markets didn’t reflect the risk that at some point QE might come to an end. The restoration of a term premium may continue to exert upward pressure on yields, but other forces in the bond market continue to strain in the opposite direction.
Investors should diversify away from government bonds where real yields remain largely negative and move into areas such as asset-backed securities and financials.
With government bond markets at a tipping point, we might expect further such opportunities as the year unfolds.
Anthony Gilham is manager of the Old Mutual Voyager Strategic Bond fund
