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​Why Brexit could land a blow on bonds

MoneyWatch headlines for June 30, 2016
MoneyWatch headlines for June 30, 2016 01:06

U.S. equities continued their post-Brexit rebound on Wednesday as investors responded to stability in the currency market based on hopes and rumors of coordinated central bank intervention.

And that's revealing a possible danger for bond investors -- who enjoyed nice gains during the recent market unpleasantness -- as the year goes on. U.S. Treasury bonds dramatically weakened into the close on Wednesday, with the 10-year yield pushing back above 1.5 percent (when bond prices drop, their yields rise).

The thinking is that any ongoing economic or market weakness will keep the Federal Reserve from hiking interest rates until December at the earliest. A rate increase would weaken bond prices by pushing up expectations for inflation and economic growth.

Amid the chaos and panic last week, traders increasingly priced in a near-term rate cut from the Fed instead of another hike. Current futures market pricing doesn't have the Fed moving on rates again until the end of 2017.

Everyone is realizing the U.K.'s exit from the European Union is likely to be a drawn-out affair (the EU's Article 50 exit clause isn't likely to be triggered until late this year, opening what's likely to be multiyear negotiations). That means Brexit could be a persistent headwind on global growth as the divorce drags on.

Investors expect major central banks to unleash fresh policy easing in the months to come. Hopes are high that the Bank of England and the European Central Bank take action. Capital Economics believes the BoE will cut rates by 0.25 percent in July, while the ECB is likely to extend the duration of its asset-purchase program (which now includes corporate bonds in addition to government paper).

Paradoxically, lower short-term interest rates should do much to boost long-term interest rates, which have been depressed in recent months. About a quarter of the global long-term government bond market trades with negative yields. The only way to change that is to increase hopes of higher growth and higher inflation.

Here at home, inflation expectations have been falling since 2011. There was a brief rise in 2012-2013 as the Fed unleashed the QE3 bond-buying program and the ECB stepped up its efforts to fight the eurozone debt crisis.

During this time, the iShares 20 Year Treasury Bond Fund (TLT) -- a "defensive" T-bond exchange-traded fund focused on long-term government bonds -- fell from a high of $118.78 per share to a low of $94.39. That's a nausea-inducing loss of nearly 21 percent, in just over a year, for a fund invested in an asset class widely believed to be risk-free.

For more perspective, consider that the TLT is currently paying a dividend yield of just 2.4 percent.

Trouble for the economy, and inflation expectations, started in 2014 as oil prices peaked and commodities in general rolled over. T-bonds got a boost, with the TLT fund hitting a peak of $140.13 on Wednesday -- up 48 percent from that 2013 low.

Assuming Brexit risks are enough to kick the central bankers back into gear -- and keep the Fed on hold -- it'll be bad news for bonds. Confirmation of this at the Fed's July policy meeting would result in selling pressure against long-term T-bonds.

But for another safe haven asset class, one that benefits both in times of market turmoil and when inflation is rising, that situation is a perfect setup for higher prices. I'm talking about precious metals. No wonder silver prices surged to levels not seen since September 2014 on Wednesday, with gold not far behind.

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