Has the Bond bull market run out of steam?

02/11/2016

| 02-11-2016 | Lionel Pavey |

building2The yield on Dutch 10 year government bonds has increased sharply in the last month (October 2016) –from 0.02% at the start of the month to 0.28% at the end – bond prices of course move in the other direction and have gone down. Why?

Possibility that the Federal Reserve will raise rates in America? Uncertainty over when the ECB will end their QE programme and the knock-on effects in the market?

ECB president Draghi has not said if the programme will end in March 2017 as originally envisaged. As monetary policy has not delivered the boost to the economy that was expected, maybe it is time for Government to look at changes to the fiscal policy via a Keynesian stimulus leading to lower taxes and an increase in direct government spending.

So if the bond market has reached the bottom and prices will start to rise, what will be the consequences?

The ECB is holding over EUR 1 trillion worth of bonds – can they unwind this position? Immediate selling would lead to a collapse in prices and a large increase in interest rates – deflating an already fragile economy and withdrawing liquidity from the financial system. Could the debt be monetized – the scale involved has never been seen before, so difficult to say.

But, what will happen to bond prices when yields start to rise?

If the yield on 20 year government bonds in the EU was to increase by 2% from their current levels, this would lead to a fall in price of 25%. If the yield on 30 year government bonds in the EU was to increase by 3% from their current levels, this would lead to a fall in price of 44%.

As the ECB would have to sell their existing bond holding at lower prices, there would be a huge loss on their portfolio – who ultimately would have to bear this loss?

What would be the effects on the equity markets – there has to be a knock-on effect if bond yields rise leading to a fall in equity prices. Is the current fragile market able to absorb these transactions – is there enough liquidity in the market?

Very worrying times ahead – companies will have to review their funding strategies, but this can lead to opportunities.

Lionel PaveyLionel Pavey – Cash Management and Treasury Specialist

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