I have been bearish on government bonds
since March this year and have repeatedly warned that they were an overpriced
asset class, saying at the time: “… one should be cognizant of the fact that an
investment in a 10-year Treasury Note will by definition lock in a total return
of 3.5% over the next 10 years. This sounds unsustainable and I find it
difficult to see the long-term investment merit of such an investment.
Long-dated bond prices could be hit hard once yields adjust to more realistic
levels.” (See “Long
Bonds in Injury Time”, March 28,
2008.)
Although rising bond yields have been
given a reprieve as a result of the deteriorating outlook for economic growth
and commensurate safe-haven buying, I maintain that the medium-term outlook
remains negative owing to valuation levels still being stretched, especially in
the light of mounting inflationary pressures.
The chart below shows the long-term
pattern of US ten-year Treasury bond yields and specifically the low of 3.14%
reached on March 17 and the subsequent turnaround.
Source: StockCharts.com
A very apt and well-reasoned summary of
the various factors impacting the outlook for government bonds appeared in
The
Economist a few weeks ago. This article is
greatly complementary to my previous posts on bonds and is therefore republished
in full in the paragraphs below.
“The yield of Treasury bonds is
arguably the single most important indicator in financial markets. Since the
American government is unlikely to default, the bond yield sets the risk-free
rate against which other assets are measured. It also serves as a barometer of
investors’ feelings about economic variables like inflation and
recession.
“But precisely because it does so many
things, the Treasury bond can send out conflicting signals. Consumers have been
grumbling about the inflationary impact of higher oil and food prices for a
while. But bond investors have only recently taken fright, pushing the yield on
the 10-year Treasury bond above 4% on May 28, for the first time since the start
of the year.
