Investors dump bonds as reflation trade takes hold

Added 9th January 2017

European investors sold off all types of bonds and bought US equities in November as bond yields and inflation expectations surged. Has the great rotation now finally started?

Investors dump bonds as reflation trade takes hold

While fund buyers were binging on US equities, they sold fixed income funds in record amounts. Combined net outflows from bond funds across the credit spectrum reached an all-time monthly record of €18.5bn (£15.8bn, $19.5bn) in November, according to Morningstar’s fund flows figures. Probably of little surprise is that the lion’s share of the outflows came from actively managed funds.

Morningstar’s asset flow figures confirm preliminary data released by Bank of America Merrill Lynch a couple of weeks after the US election that a ‘great rotation’ from bonds to equities was taking shape. However, similar calls have been made many times over the past couple of years: and they have been wrong on each of these occasions.

Reflation

To make investors abandon bond funds, interest rates and inflation will need to rise on a sustained basis, and that what seems to be happening right now. US 10-year yields have risen by more than 60 basis points in the past two months, as the Fed has pledged to hike rates at least a few times this year, depending on Donald Trump’s fiscal policies. While the ECB remains dovish for now, it is scaling back its stimulus measures. And euro area annual inflation exceeded 1% in December, for the first time since 2013.

Accelerating economic activity on both sides of the Atlantic completes the backdrop for a great rotation. Europe’s fund investors have been intending to reduce their government bond exposure for a while, but their numbers have never been as big as they are now. According to our sister publication Expert Investor’s latest asset allocation survey, a record 51% of fund buyers plan to decrease their allocation to the asset class over the next 12 months. By contrast, buyers outnumber sellers in all equity asset classes.

A lasting change?

Chris Iggo, fixed income chief information officer at Axa IM, concedes the current macroeconomic environment doesn’t bode well for bonds. “A potential playbook for bonds over the next year or so is that rates keep on rising as the US economic upturn spreads to other parts of the world and this at some point translates into much tighter financial conditions,” he says.

"Treasury yields above 3% might be the trigger for the rotation back into government bonds" - Chris Iggo

These tighter conditions may translate into lower economic activity and drive investor confidence down. The start of a Fed rate hiking cycle is traditionally followed by a market correction a few months later. Any sign of this would drive investors back into government bonds.

Finally, the term ‘great rotation’ suggests something of a permanent nature, which of course will not be the case. Not only is there an increasing secular demand for bonds due to ageing, at some point government bond yields will have reached levels that make them attractive again. “Putting numbers on this is never easy but Treasury yields above 3% might be the trigger for the rotation back into government bonds,” says Iggo. Since US 10-year yields are less than 60 bps away from this 'magic number', the 'Great Rotation' might indeed be short-lived.

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About Author

Tjibbe Hoekstra

Senior Reporter

Tjibbe joined Expert Investor as a senior reporter in March 2014. Before moving to London he worked as a financial news reporter for various news outlets in Amsterdam, including Reuters and ANP, the main news agency in the Netherlands. He also worked for Fondsnieuws, a website and magazine for finance professionals in the Netherlands. Tjibbe holds a MSc in Public Administration and a post-graduate diploma in Journalism.

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