When benchmark German and US bond yields were last at their current low levels, the Federal Reserve had just launched its second round of “quantitative easing” and pressure was growing in the eurozone for an Irish bail-out.
That was November 2010. Equivalent UK gilt yields, however, have never been this low; on Tuesday the 10-year yield, which moves inversely to prices, fell to a record low of 2.76 per cent.
Some of the bond buying – which pushes up prices and lowers yields – has been linked to investors’ efforts to find havens for their cash as they seek a clearer picture of the economic outlook.
But the recent falls, which have been gathering pace, speak to a different strategy. The fog over the future is in fact clearing, and bondholders have made their choice and are bracing for, at best, a sharp economic slowdown.
“It is hard to see any good news on the horizon at the moment,” says Jim Leaviss, head of retail fixed income at M&G, who describes current yields as “justified.”
“They are saying there is a good chance of a recession,” he adds.
The reasons for the gloomy sentiment are clear. Data on Friday showed the US economy growing at just 1.3 per cent a year in the second quarter, well below expectations in a report undermined further by heavy downgrades to previous readings.
This week, several manufacturing activity reports – often correlated with stock market performance – pointed to slowing growth. Attention will now turn to Friday’s US employment data.
“Unless we are missing something the US is one false move away from a recession,” says Jim Reid, strategist at Deutsche Bank, who has warned the US could be approaching a “1937 moment” – when authorities removed post-Depression stimuli from still-fragile markets and triggered another recession.
This risk, he says, has in fact only been magnified in the markets’ eyes by agreement on raising the US debt ceiling.
“The debt ceiling accord as a minimum starts to rein in the US’ aggressive post-crisis stimulus and, importantly, the perception that governments can keep the taps flowing indiscriminately,” says Mr Reid.
The question for markets then is, if the economy worsens further and governments cannot help, how much can the monetary authorities do? This has triggered growing talk of further quantitative easing, another round of emergency bond-buying or “QE3”, as it has already been dubbed in the US.
The bar for another round of QE, which could stoke any inflationary pressure, is high, however. US data on Tuesday showed that the annual pace of core inflation rose to 1.3 per cent in June from 1.2 per cent in May, and is expected to rise further.
UK inflation is running at 4.2 per cent and in the eurozone at 2.5 per cent.
“Fundamentally, I don’t see QE3 and would not like to see it, but you can’t rule it out,” says Michael Kastner, principal at Halyard Asset Management.
The European Central Bank and the Bank of England both hold rate-setting meetings this Thursday and the Federal Reserve meets early next week.
With the Fed holding its annual Jackson Hole symposium later this month and the Bank’s inflation report due next week, neither is expected to say much new, leaving investors to focus on the press conference held by the ECB.
For bond investors, the rally has produced unexpectedly good returns to date this year as falling yields have boosted prices – when many had been bracing for interest rate rises to push yields higher.
“Its all about capital preservation. There’s been a big demand for cash, so if people are happy to get zero [for cash deposits] then bonds at least are returning something,” says Steven Major, head of global fixed income research at HSBC.
The next big question for investors is whether yields will go even lower if growth worries dominate and the QE chatter grows, or whether concerns about the danger of rising inflation will bring out the bond market’s famed “vigilantes” and force yields higher.
Mr Major thinks Treasury yields could fall to perhaps 2.5 per cent.
“It’s consistent with low growth and the big change in peoples’ growth expectations this year,” he says.
He also believes UK gilts, where inflation fears have been strongest, are coming around to the Bank’s view that inflation pressures are temporary, damping potential yield rises.
But Patrick Armstrong of Distinction Asset Management thinks virtually the opposite – thus underlining the dichotomy facing the bond markets. He believes UK benchmark rates will be nearer to 4 per cent than 3 per cent this time next year.
“We’ll see yields pick up at the longer end as the vigilantes come in – it’s hard to call inflation transitory forever,” he said.