Government bond markets used to be conventional. Macroeconomics departments at prestigious universities all taught the ancient (given the short history of economics) orthodoxy of GDP, inflation, current account balances and unemployment all determining government bond yields. But the old truths have stopped working lately.

Take steadily rising employment across the Eurozone since 2013 – did this spur inflation and drive bond yields upwards? No…

How about a decade of rising US consumer confidence – has this driven 10-year Treasury yields to 5%? Try 1.7%….

Times have changed, and so too have the variables that affect bond yields. The textbooks of 20 years ago simply don’t work in today’s world of quantitative easing, negative interest rates and trade wars. Instead, we can see the new determinants of government yields recently have been market inflation expectations (5y5y inflation swaps), market expectations of central bank rates, forward guidance from the Fed, and the positioning of hedge funds.

So let’s assume that today’s relationships hold – an imperfect assumption I agree, but recent history is a better predictor of the near future than things that drove markets 50 years ago. How should we position a government bond portfolio through to the end of the year?

Inflation expectations have collapsed, rate expectations in the US and Europe – and globally – are for more rate cuts this year and into 2020, and Fed communication on rates has been shifting downwards all year. I think in this environment you own bonds. That’s the medium term trade where inflation is going nowhere and central banks are going to buy assets for a very long time.

In terms of value, bond investors often look at carry – in other words, the return you get from holding the bond and assuming that rates don’t go anywhere. But carry is not a very good indicator of the return from holding a bond over your investment horizon. Italian bonds may be good “carry” at 1.4% over the German equivalent, but you are going be looking at a big hole in your fund performance if you buy them today and they blow out to 3% tomorrow. A much better indicator of the attractiveness of an investment is not the carry, but the carry adjusted for the volatility of the asset. Volatility adjusted carry (VAC) has been proven over certain time periods to be significant in producing an excess return.

Looking at VAC, in my chart below, 5-year Greece is the most attractive government bond asset to own. I like the improving credit story and overarching ECB support. So from here I stay long Greece – maybe I’ll sell when the ECB wants to buy them from me.

Source: Bloomberg


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