Government bonds: Still a safe haven?

How much can we rely on government bonds for safety in the context of a US administration seemingly intent on stoking inflationary pressures?

The investing backdrop is as complex as it has been in a while.

On the one hand you have central banks trying to delicately extract themselves from largely successful post-Crisis monetary experiments, whilst also gently letting the air out of the multi-decade bull run in bonds.

Sharply higher inflation would obviously be unwelcome. On the other hand you have a US administration seemingly intent on stoking such inflationary pressure.

In theory, adding tariffs on imports and dumping a load of spending and tax cuts on an economy operating at or around full employment should see prices in the economy rise in time.

How does one find safety in a world where the behaviour of the ultimate safe haven is potentially the main threat to investors?

Dollar over Treasuries

So far the long end of the US Treasury market is holding firm. 10-year yields have retraced lower in Q2 amidst rising trade tensions and weakening growth momentum (Figure 1). But we’ve seen earlier this year how abruptly the bond market’s narrative can change.

US 10 year Treasury yields

Year-to-date, US Treasuries have not recovered from their February sell-off, when markets were pricing in a brighter inflationary and growth trajectory for the US economy.

With US core inflation readings steadily grinding towards the Federal Reserve’s 2% target amidst declining economic slack, data over the coming months could well jolt the US bond market again.

As such, we think that the second half of the year contains further upside risks for long-end Treasury yields. For now, duration risk is not something we are comfortable loading up on when it comes to US Treasuries.

To us, cash and near-cash assets provide a better risk/reward ratio relative to long-end Treasuries. With the US Treasury curve at its flattest in years (Figure 2), cash offers a similar yield to long-end Treasuries, but with lower duration risk.

US yield curve is relatively flat

Within our asset allocation framework, this allows us to go up to 3 year issues, allowing us some flexibility beyond the simple interest rate on deposits. US investors are fortunate in this regard, with US dollar cash now offering real return beyond the 3 month tenors.

Such opportunities are unfortunately scarcer in the rest of the developed world – the European bond market remains steep, while lending to the UK government for 30 years still offers you a negative real return!

Investment conclusion: quality over quantity

All the assets within our nine asset class framework have ever-changing strengths and weaknesses. We organise these assets together to try and position our clients to receive the returns they are realistically looking for, as regularly and reliably as that profoundly unknowable future will allow for.

Higher quality government bonds are of course part of that organisation, even in the small quantities we currently recommend.

Outside of the US, cash holdings are more for risk dilution purposes than prospective real return.

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