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Bonds as a "safe haven" - just an old fairy tale?

"Government bonds have long been considered a 'safe haven', but have suffered record losses in recent months," says Dr Volker Schmidt, Senior Portfolio Manager at Ethenea Independent Investors S.A. European investment-grade bonds lost an average of more than 13 percent in the first six months of this year alone. Yields on 2-year US government bonds have even quadrupled since the beginning of the year from 0.75 percent to more than 3 percent.

The end of the monetary policy crisis response

As a result of the Corona-induced economic collapse, almost all central banks cut interest rates to or near 0 and bought bonds in record volumes, according to Dr Schmidt: "The subsequent recovery of the global economy, full employment as well as rising inflation rates prompted the Fed to change its policy in the second half of 2021." First, the Fed reduced its bond purchases and ended them completely in March 2022. Since June, it has been reducing its holdings of government bonds and mortgage-backed bonds. New investors will have to be found for this huge amount of government bonds. The Fed's change from buyer to seller of government bonds is not conducive for the safe haven status of government bonds. The ECB is pursuing a similar policy, only with a time lag. Its bond purchases will no longer continue in July and the first interest rate hike will follow in the same month. "The only thing the ECB is struggling with is reducing its accumulated bond holdings. According to its official statements, maturing funds are to be reinvested at least until the end of 2024. Perhaps the ECB will change its opinion and its policy completely by then," speculates Dr. Schmidt.

Inflation remains high

Yields on 2-year US government bonds now exceed 3 percent and 10-year bonds yield around 3.25 percent. This is in contrast to inflation in the US, which is above 8 percent for the third month in a row in May. "This is miles away from the Fed's inflation target of 2 percent annual inflation," the fund manager explains. "Fighting inflation is therefore the US central bank's stated primary objective." Therefore, the Federal Reserve had also set a clear signal in June with an interest rate hike of 0.75 percent and announced further massive interest rate hikes. According to Dr Schmidt, even if inflation slows down in the months leading up to the end of the year, it would still be over 6 percent. Accordingly, the Fed will raise its key interest rate to around 3 percent by the end of 2022 at the latest.

"We therefore think further losses on US government bond investments are likely by the end of the year, although not to the extent of recent months," says Dr Schmidt. The situation is similar in Europe. Inflation in the Eurozone is at 8.1 per cent and thus just as well above the ECB's target. Yields have risen significantly, he says, even yields on 2-year German government bonds are now around 1 percent, having been -0.8 percent last summer. "Even though most of the losses have now been realised, we still expect further, slight losses for euro-denominated bonds," Dr Schmidt added.

The "safe haven" potential of bonds

The Russian invasion of Ukraine had helped government bonds to short-term gains at the end of February and thus signalled that the security aspect can always be an investment motive for investors. Likewise, the word 'recession' has recently been appearing more frequently again in economic commentary - as has mention of a possible policy error by the Fed for raising interest rates so sharply. "These messages have the potential to increase investors' need for safety and boost demand for US 10-year Treasury bonds," explains Dr Schmidt.

In the event of an economic downturn, the Fed could be faced with the dilemma of continued excessive inflation coupled with job losses. " Powell has now also made it clear that the Fed will prioritise fighting inflation in this case," says the fund manager. After a hike in central bank interest rates to 3 percent, however, the Fed is likely to pause and wait for the time being. Starting at a level of 3.5 percent, 10-year US government bonds would also be a 'safe haven' again with rather limited loss potential and an attractive coupon. "However, we think that the safety aspect will only become really convincing for investors after a completed increase in central bank interest rates in the USA, especially if the recession fears intensify."

In the eurozone, German government bonds are considered safe havens. Yields on 10-year German government bonds are currently around 1.6%. "The potential for price gains even in the event of a looming recession is significantly lower than for their US counterparts, as we rule out a return of the negative interest rate phase," says Dr Schmidt. "Their scarcity, as well as the much lower level of government debt, makes German government bonds stand out."

Putting debt sustainability under the microscope

In the long run, debt sustainability weighs immensely on the character of government bonds as a "safe haven". Due to the massive increase in government debt worldwide, the refinancing of the huge debt mountain will become more and more expensive with permanently higher yields, thus burdening the national budget, even if only in the very long term.

"According to calculations by the Congressional Budget Office in the USA, net interest payments will fall slightly in the next two to three years to below 1.5 % in relation to gross national product, but then rise to 8 % by 2051," explains Dr. Schmidt. The picture is even more gloomy if one relates net interest expenditure to total government expenditure. These would rise from 8 % to over 30 % in the same period.

"If doubts arise for this reason about the ability and willingness to refinance existing debt, then the status as a 'safe haven' is seriously in question, as the sovereign debt crisis in Europe about 10 years ago demonstrated forcefully," says the fund manager. "We do not doubt the ability of the US to refinance at any time, even if the will to do so seems to be lacking at times." Regularly, due to partisan power plays, solvency is only secured at the seemingly last moment by making the necessary compromises. In addition, the US state has only had an "AA+" rating as an issuer since 2011. "However, we at ETHENEA are certain that the USA will continue to meet its obligations at all times in the future and that US Treasuries will therefore continue to have the potential to be a "safe haven"."

In the Eurozone, there is no reason to doubt the will to pay debts, Dr Schmidt is certain, even though the sovereign debt crisis 10 years ago called into question the solvency of many European states. "Bonds from the peripheral countries such as Italy, Spain and Portugal have not been a 'safe haven' for a long time and will not become one in the foreseeable future". They would benefit from a communitisation of debt in the Eurozone. The exact opposite is true for German government bonds. "As long as this does not happen, German government bonds will remain the "safe haven" of Europe," said Dr Schmidt.

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