I have posted before that I expect that US government bonds may prove the worst investment class over the next few years (see Investment Themes post) and that recent yield levels driven by extreme risk aversion were unsustainable. Yesterday, bonds across the world slumped to multi month lows, ostensibly in reaction to the mildly positive US durable goods numbers, with the benchmark 10 year hitting over 4% in the US, 5% in the UK and almost 1.8% in Japan. This could be the beginning of a secular bear market after an historic 25 year upswing that began under the inflation busting Volcker Fed in the early 1980's and boosted by the dis-inflationary windfall from the long commodity bear market and outsourced Chinese manufacturing through the 90's. Announcements like Dow Chemical's 20% price hike yesterday are a sign of things to come as rising industrial feedstock and transportation prices become embedded in general inflationary expectations, just as manufacturing costs in China are rising sharply with sub 4% local unemployment and 20% plus wage rises (see China at Breaking Point). Markets are now discounting a 60% chance of a rate hike from the Fed as soon as October, a dramatic turnaround from the complacency that reigned a few weeks ago (and supportive of my bullish dollar view; the basing pattern of the past few weeks augurs well for a significant rally over the Summer). A remarkably benign period for fixed income investors may be well and truly over as globalisation bites back with a vengeance, and this looming historic reversal would have broad implications across all markets. Short term, if the oil bubble bursts as I expect in coming weeks, bonds could stage a technical rally in relief but it's conceivable that 10 year yields in the US will hit well over 5% plus over the medium term, assuming the sort of protracted but shallow recession I think likely coinciding with persistent inflationary pressures. Unless we see a deflationary shock to global demand, corporate and mortgage bonds offer selectively better value, and it's no surprise that the savviest institutional bond investors like PIMCO are now massively overweight these areas versus sovereign bonds. Follow the (smart) money...
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