Sovereign bond markets are priced for deflation in a world that is mildly inflationary, making the potential for volatility “extremely high”, says Nikko Asset Management.
Speaking in Sydney, Nikko Asset Management global head of multi asset Al Clark said the negative correlation between bonds and equities may be starting to break down.
In the past 15 years, Mr Clark said, the benefit of having bonds in a portfolio is that they rally when equities sell off.
But now that bonds are so expensive, the negative correlation between the two asset classes is no longer set in stone, he said.
“If we’re getting to the point where sovereign bonds are so expensive that they’re going to struggle to rally, then that correlation breaks down,” Mr Clark said.
Investors tend to forget that from the 1970s to the mid-1990s there was a positive correlation between sovereign bonds and equities, he said.
“I’m not suggesting we’re going to move from what’s been this negative correlation regime for 15 years straight to a positive correlation,” Mr Clark said.
“But if you’ve been looking at markets over the past couple of months you will have noticed that that’s exactly what’s happened in the short term.”
Last week, US equities sold off 2 per cent and US Treasury yields moved 10 basis points higher, meaning that both asset classes sold off equivalently, Mr Clarke said.
Given that bonds are so expensive, Nikko Asset Management is concerned about what will happen if they suddenly reprice, he added.
“We’re in a deflationary environment. People are talking about disruptive technology, demographics, savings glut and the stock of debt,” Mr Clarke said.
“Unfortunately, deflation doesn’t exist much in the world. Much of the world’s actually going through small levels of inflation.”
Because bond markets are priced for deflation, there is potential for a “dramatic repricing”, Mr Clarke said.
“We don’t have to see a lot of inflation for bonds to suddenly move 1 per cent higher in the US – or even in Australia,” he said.
“If you look at the last few weeks, bonds have moved 40 basis points in the 10-year market.”
The knock-on effects of a “dramatic repricing” in bond markets could flow on to other asset classes, he said.
“Unfortunately, a lot of the equity pricing has been founded on low rates forever,” Mr Clark said.
“All of the assets that have used that low bond price as their foundation; they could all reprice as well.
“The potential for volatility to us at this point in time seems extremely high.”
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