Bond Market Bubble, or Not?

Yields in the major bond markets are at their highest levels in over three months and energy prices touching 12-month highs is a warning over the risks of a sudden regime shift in monetary policy expectations. Government and company bonds have been orbiting record highs in recent times. The volatile proportionality of these bond prices to their yields are also raising concerns, as prices are at major highs and the yields are taking a beating unable to leave the ground at record lows. Capital inflows from investors into bonds and bond funds are also on the rise as investors, wary of stock valuations are searching desperately for yield. Bond prices fell surprisingly in September when the market was filled with speculation that the Federal Reserve and many other central bank would tighten their monetary policies. The decrease in Bond prices has since been reversed as investors are now more confident that the Fed will move sluggishly when they eventually decide to raise rates.

A further increase was seen today in the global bond markets, progressing the move seen over the last week. For the first time since the June Brexit vote, UK yields have edged past the 1.0% level, as US 10 year yields have grown by about 1.75% reaching a four month high, the official market is however closed for the holidays. The benchmark German 10-year yield has also broken back above zero.

The recent bond markets streak has many investors on edge and not just investors are nervous. Last week Ray Dalio, the founder of $US160 billion hedge Bridgewater Associates, warned of a "big squeeze" in a speech that he gave at the US Federal Reserve Bank of New York's 40th Annual Central Banking Seminar. Dalio also stated that, "rarely do we investors get a market that we know is overvalued and that approaches such clearly defined limits as the bond market now."

With the Federal Reserve now looking more likely to raise rates after the latest employment report, investors are fleeing the bond market, yields are now spiking higher in Germany, the US, Japan and even here in Australia. In July the yield on the benchmark US 10-year bond was changing hands at around 1.38 per cent, but now that has risen to around 1.8 per cent.

It might not look much of a move, and yields by historical standards are still very low, but as Dalio chillingly pointed out, "it would only take a 100 basis point rise in Treasury bond yields to trigger the worst price decline in bonds since the 1981 bond market crash. And since those interest rates are embedded in the pricing of all investment assets that would send them all much lower."

A few months ago Goldman Sachs estimated that if the Fed did hike rates by 1 percentage point it would wipe out $US2.4 trillion ($3.1 trillion) from the government bond market. Markets often take a lot of convincing that underlying trends have reversed, but they are also prone to a sudden shift and a new paradigm. The latest bond-market and energy-market developments are a warning that such a shift could be underway.