Caution at the yield signs

US bond yields continued to climb overnight, as investors continued to shun low-yielding ‘safe' assets and to rush into more risky types of investment.

Long-term US bond yields (which move inversely to prices) are now trading at their highest level in five months, with 10 year bonds – a key rate for US government borrowing – now yielding 2.28 per cent.

For the past six months, 10-year US bonds have traded in a tight range – yielding between 1.8 per cent and 2.1 per cent. In the last seven trading days, however, 10 year bond yields have spiked by 0.43 percentage points.

This recent surge in bond yields suggests that investors have now become much more confident about the US, and even global, economic recovery.

In September last year, investors started snapping up bonds as they worried about the faltering US economy and the prospect of major defaults in the eurozone. The US central bank also put downward pressure on long-term bond yields by announcing 'Operation Twist', which involved it selling $400 billion of short-term bonds and reinvesting the proceeds in long-term bonds. As a result, US and German bond yields fell below 2 per cent for the first time since the 1950s.

But now investors are responding to signs that the US labour market is improving and economic activity is picking up, while inflation remains subdued. And with signs that the US economy is on the mend, investors believe that the US central bank is unlikely to commence a new round of bond buying – or QE3 – in order to push long-term bond yields lower.

At the same time, there's hope that global economic activity could rebound now that all the major global central banks have unleashed fresh monetary stimulus, while fears over a major eurozone debt crisis have also faded now that the second Greek bailout appears on track.

But other analysts are worried that a major correction in the bond market could prove a drag on the US economic recovery, and batter fragile household and business confidence. What's more, they argue, rising bond yields will translate into higher mortgage costs, which will hurt the troubled US housing market. Higher bond yields are already been passed through to home loan borrowers, with the average base rate for a 30-year mortgage now at 4.19 per cent, compared to 4.05 per cent only a week ago.

Even worse, there's a risk that the US central bank may decide that rising bond yields pose a threat to the fragile recovery, and that it needs to trigger another round of quantitative easing, which would push commodity prices higher and flame inflationary pressures.

Analysts are also divided about how far the sell-off in bonds will run. Some argue that bond yields are likely to start falling again in coming months as the US economy's performance proves disappointing, and as fresh tensions emerge in the eurozone.

However, more bullish analysts are tipping that the US economic pick-up will continue, and that US 10-year bond yields could eventually climb back to 3 to 4 per cent. This would leave bond investors nursing hefty losses of between 10-15 per cent.

However, as GaveKal's Anatole Kaletsky points out, equity investors are unlikely to suffer a similar fate. As he notes, "there have been seven serious bear markets in bonds since 1982, each involving losses of 15 per cent to 20 per cent in 30-year Treasury prices. Not a single one of these major bond corrections has caused a bear market in equities; two have coincided with flat equity markets (in 1984 and 1994); and five have coincided with big equity gains (early 1987, 1999, 2003, 2009 and late 2010).”

Kaletsky also argues that the bond market is dangerously overbought at present. "While everyone worries that equities have advanced by 20 per cent in just five months, without a meaningful correction, the 20 per cent jump in bond prices in the past 12 months is actually much more unusual.”

He notes that there have been eight periods in the past two decades where equities have risen by 20 per cent or more in five months "and these have generally been followed by nothing more painful than a slowdown”.

In contrast, bond prices have only risen by 20 per cent or more over a 12 month period once before (in 1995). And the four other times when bond prices rose by more than 15 per cent in a year "were all followed by memorable bond meltdowns – in 1994, 1999, 2003/4 and 2009”.