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August 2020 featured a low volatility environment compared to previous years, as sentiment around the macro backdrop and the Covid-19 recovery improved, and the ongoing growth in central bank balance sheets proved a boon for risky assets. But with economic data having little impact on prices and a larger share of the market owned by domestic commercial banks, are developed government bond markets at risk of Japanification?Andrea Iannelli, Investment Director, Fidelity International, discusses this in Fidelity’s latest fixed income outlook.

  
“With the US elections approaching, the main risks now lie on the fiscal, rather than monetary policy side. There is this assumption that ‘whatever it takes’ fiscal policy will continue but this level of spending is unsustainable. Investors are also giving little attention to the recent sharp growth in fiscal deficits. How these deficits are eventually going to be funded and which areas of the economy will be targeted for tax increases need to be addressed.
 
“The latest US fiscal package expected to be approved in early September amounts to USD500 billion. In the pipeline there is also the USD3 trillion package announced by Biden for a “green new deal” and possibly more if Democrats get a clean sweep. However, fiscal news appears to have little or no impact on government bond yields, despite little inclination by governments to consider how to ‘balance the books’, an unpopular topic in most countries.
 
“The latest market dynamics appear to confirm our view that developed government bond markets are on a path to “Japanification”, with economic data having little impact on prices and a larger share of the market owned by domestic commercial banks, a trend that is becoming particularly evident in the US. Yields are thus likely to remain in check within  the tight ranges that we have seen in the past few months, and any yield increase likely to be short-lived.
 
“In Europe, little changed in the September ECB meeting, with the central bank keeping its options open and leaving any further policy action till later in the year. On the fiscal side, current government spending is unlikely to be enough to carry economies till the “end” of Covid, and this is particularly the case in Europe, where the room and willingness to manoeuvre appears less than in the US or the UK. Bunds are in the middle of the recent range, leaving us with little conviction either way at current levels. In Periphery Europe, meanwhile, we have gradually reduced our exposure and are now underweight, with valuations that appear stretched after the rally that we have seen in the past few weeks.
 
“Lastly in the UK, unemployment is expected to rise in the months ahead as the fiscal packages to support workers roll out, putting downward pressure on wage inflation. Whether that is enough to reduce CPI levels or at least not allow them to increase too much more is yet to be seen. At current levels, we favour a more cautious stance towards UK duration and Gilts, with short-term risks of higher yields. This view, however, is a tactical one, and we are unlikely to break out of recent ranges.”