Beware Bond-Market Mood Swings
From hero to zero in just 10 days: May's selloff has seen year-to-date gains for holders of U.S. Treasurys, German bunds and U.K. gilts wiped out and turned to losses. Some are asking if this is a definitive turning point for the bond market after its 30-year bull run. It isn't clear yet that global yields have hit bottom--but it is clear that bonds are becoming hypersensitive to the smallest twists and turns in the economy.</br></br>The turn in mood has been sharp. On May 2, after the European Central Bank cut rates and hinted that it might yet push the rate on its deposit facility into negative territory, 10-year German yields hit a record low around 1.15%; U.S. yields were at a low for the year of 1.63%. But since then, a better-than-expected U.S. jobs report, some encouraging German industrial data and a brewing debate about how and when the U.S. Federal Reserve might wind down its bond-purchase program have pushed yields sharply higher, to 1.36% in Germany and 1.92% in the U.S. Gilt yields have broadly tracked Treasurys.</br></br>But none of the data yet suggest an economy that is standing on firm ground: U.S. payrolls growth of 165,000 in April was better than expected, but hardly stellar, albeit prior months were also revised upward. Better data for Germany is welcome, but is unlikely to pull the euro zone as a whole out of its extended slump. Other indicators continue to suggest a soft patch. Most significantly, key measures of inflation have been falling, which should be bond-friendly: In the U.S., the core Personal Consumption Expenditure measure, the Fed's favored inflation gauge, has dropped to 1.1%, while euro-zone inflation is estimated at 1.2% in April, down from 1.7% in March. And since the start of May, the ECB, the Danish central bank, the Reserve Bank of Australia, the Reserve Bank of India, the National Bank of Poland and the Bank of Korea have all cut rates--between them accounting for some 23% of world GDP, notes Deutsche Bank.</br></br>Further falls in inflation may yet scotch talk of tapering bond purchases in the U.S. In the euro zone, the ECB may yet become more dovish. And the full effects of the Bank of Japan's new activism have yet to be seen--although Japanese net purchases of foreign bonds have now turned positive, another potential support for U.S. and European markets.</br></br>Still, the violence of May's selloff suggests that with yields at such low levels, investors are very sensitive to any data that goes against expectations and are very quick to try to judge what that means for central-bank policy. That means more volatility lies ahead. Investors should watch out.