After the recent reminder of the power of bond markets in relation to President Trump’s tariff announcements, Liontrust’s Phil Milburn explains why they have such an impact and what they are currently telling us about the economic outlook
Simon [00:00:11] I'm Simon Hildrey and with me is Phil Milburn to talk about both the power of bond markets and what they're telling us at the moment. Phil, we've been reminded yet again recently about the power the bond markets and James Carville, an advisor to President Clinton, famously remarked that rather than come back to life as a baseball star or even as president, he'd rather come back as the bond market so he could intimidate everyone. Can you just remind us why bond markets are so powerful?
Phil [00:00:40] It's worth bearing in mind the bond market only matters if you need it, and the US definitely needs the bond market at the moment. They're running with a fiscal deficit in the region of 6.5% to 7% of GDP and someone has to finance that. Add to that, there's a constant need to roll debt to the short end as treasury bills and longer dated bonds roll down and start maturing. So there's need for constant access to the bond market. If interest rates, yields on bonds start to really increase, the cost of that to the US and the extra cost on the fiscal side will start to spiral very quickly.
Simon [00:01:20] Does that mean the power bond markets varies over time then?
Phil [00:01:24] Definitely, yes. If we look back just over two decades ago, there was talk about the US Treasury market actually shrinking to zero. We're actually running with a fiscal surplus, looking around for other high quality bond assets to use instead of treasuries. It seems a very long time ago now, but like I say, it's all about, do you need the bond market? If you need bond market, you're going to need to play by the bond market's rules.
Simon [00:01:51] What are bond markets telling us about the outlook?
Phil [00:01:54] At the moment, the bond markets are starting to extract a little more premium from the geographies from the sovereign states they see as pushing the fiscal limit. The US is a bit of an exceptional case because globally there is still no great alternative to treasuries as the big liquid, in theory, risk-free asset. It's only called that in the capital markets. We all know there is risk there. But further afield you can look at Japan, where the ongoing fiscal spending there has started to cause a big sell-off. And briefly earlier this year, Japanese 30-year yields reached the same level as German 30-year yields. Or continued pressure in France as they struggle politically to pass budgets there. The pressure is around the world. So that's what the sovereign bond markets are telling us.
Simon [00:02:44] What about the corporate bond market? What's that telling us?
Phil [00:02:47] So the corporate bond market has been remarkably well-behaved this year. There was a small wobble during the time of Trump's big 'Liberation Day' tariff announcements, but in general corporate bond spreads, the extra yield you get over the government bond are relatively tight. The all-in yield is still generous but spreads are tight and the reaction has very much been a benign one because the corporate bond market is effectively saying that there might be an economic slowdown. There might be some margin pressure caused by tariffs, but there will be nothing so bad, not such a deep recession, as to cause an existential threat to companies' balance sheets. So it's very much deemed by the corporate bond market to be an earnings issue, but not a balance sheet issue.
Simon [00:03:34] And slow, but steady economic growth then?
Phil [00:03:38] Correct. Possibly it could even allow for a mild recession, but nothing more than that. In fact, if you were to also look at the index linked markets, we have seen treasury inflation protective securities, the inflation breakeven, is now back to where it started the year, having dipped in between with 5-year breakevens about 2.5%, 10-years about 2.4%, 30 years 2.3%. Or over in Europe, something that the ECB likes to look at, inflation swaps, are sitting there at about 2.1% at what the ECB looks at the 5-year, 5-year forward. So the market's saying inflation a little bit above target, but nothing too worrisome. And that's consistent again with an economic slowdown, but still a longer term inflationary pressure and nothing really to worry about about deep recession, otherwise inflation would collapse in that environment.
Simon [00:04:33] So should we expect interest rates to continue on a kind of slow reduction?
Phil [00:04:40] Looking around at three of the major economy, economic blocks; the ECB, European Central Bank, is likely to cut one more time this year but they deem monetary policy to be in the neutral area and they're reluctant to go much further because they don't necessarily want to get policy to be loose or accommodative. With the Fed and Bank of England it's very much still a wait and see and gradual pace.
Simon [00:05:08] Thank you, Phil, and thank you for watching. We'll see you next time.
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