31st October 2016 by Chris Iggo
The long anticipated rise in yields got underway this week. Credit has outperformed rates and inflation has outperformed nominal government bonds. Rates have bottomed – even the Brexit hit UK economy grew at 0.5% in the third quarter, reducing the need for another UK rate cut. A rate hike in the US is a greater probability than it has been for some time. It hasn’t got really ugly yet as credit and equities are holding up reasonably nicely. But if increased inflationary expectations are driving the move in rates, there is likely to be further to go. Caution prevails in this bond house.
Scream, bonds down – It’s thirty years since the Big Bang* and much has changed in the City of London. However, one thing remains constant and that is the ability of the markets to surprise investors. As we head towards the Halloween weekend, it is the bond market that is spooking people the most. Yields are up sharply this month and, if one looks at a chart of the price of a representative bond index, there has been a very distinct bearish move since prices peaked in mid-August. The UK aggregate bond index price is down 6.8% from the peak with the US and European broad markets down 2%. Of course, the UK had more to give back after the strong post-Bank of England rate cut rally in gilts and UK corporate bonds. The move in sterling, increased inflationary expectations and more optimism on global growth going into 2017 are all reasons that can be cited to justify the move in UK yields with the global bonds being driven by similar macro themes. I have been a big fan of inflation protection for some time and the move in break-even inflation rates this last few months is telling – at the 10-year horizon they are back above 3% in the UK and breaking above 1.7% in the US, compared to a low of 1.2% at the beginning of 2016. The Federal Reserve’s (Fed) favourite measure of market inflationary expectations – the five-year/five-year forward break-even inflation rate – has risen in the UK, US and European inflation markets in recent months. In summary, deflation fears have significantly receded and that reduces the need for monetary policy to take any further steps to drive down bond yields. We are normalizing.
Less pessimism – In terms of yield, the benchmark 10-year gilt is almost 80 basis points (bps) above the low it reached in August and is nearly back to the level it was at just before the European Union (EU) referendum. The equivalent German yield is a (positive) 0.2%, 40bps above its lows, while the US Treasury global benchmark yield is 50bps higher. These moves are not a surprise given how low yields got in the summer and given the turnaround in sentiment towards inflation and growth globally. Not that investors are ‘gung-ho’, but the more pessimistic views about the global economy that were expressed in the early part of the year have proved to be unfounded. China’s growth rate is remarkably stable at 6.7%, commodity prices are higher across the board and confidence in global corporate earnings, as reflected in stock market prices, has at least stabilised.
Real easing – Of course the increased probability of a Fed rate hike in December is part of the driving force behind the adjustment in yields. According to Bloomberg, the probability of a December hike is now 72.5%. While there is still some uncertainty over the result of the US Presidential election, the macro backdrop in the US is supportive of a further adjustment in monetary policy. Think of it this way, consumer price inflation is now running at 1.5%. For much of 2015 it was at zero and at the time the Fed last moved rates, inflation was just 0.5%. So it is now 1% higher while the Federal Funds rate is just 0.25% higher. Real rates have fallen on this measure. The overall US dollar exchange rate index is no higher today than it was last December (the Bank of England’s measure of the trade weighted dollar index is actually 4% lower) while the equity market is higher by some 4.4%. Overall financial conditions, in real terms, are easier than they were a year ago and, at the same time, the economy has continued to grow and the labour market has remained strong. I suspect that much of 2017 will be spent assessing the risk of even more Fed rate hikes.
God bless America – I have just spent over a week in the United States during the period which saw the final debate between Donald Trump and Hillary Clinton. We’ve been caught out by the opinion polls in a major way already this year so there is some caution attached to what I am about to write but my impression was that various events have worked against a Trump victory in recent weeks. Suggestions that the results of the election might be questioned or that the polls are somehow rigged have not gone down well with an electorate that values the sanctity of the constitution. Business people I met were somewhat guarded in terms of giving personal views on the election and there does not seem to be overwhelming support for the kind of ‘business as usual’ outcome that would come with a Clinton victory. Thus in my view the risk remains open for an outcome that is different to what the polls are saying and, with that, comes the potential for increased market volatility come the second week in November.
Bonds can get cheaper, you watch – Bond market returns are negative as a result of the moves seen since the summer. So far it has been mostly a rate adjustment with credit spreads, on the whole remaining stable. The pricing in of a slightly higher rate environment going into 2017 has not yet impacted on risk assets. However, we have seen “rate tantrums” hit credit and equities in the past and this remains a risk, especially if the data surprises to the upside. We do not believe that the European Central Bank (ECB) is going to wind down its supportive monetary policy any time soon but the underlying messaging from central bankers is less about downside risks than it has been in the past. There are risks to credit spreads in the near term – if higher rate expectations become more entrenched then corporate bond issuance could rise, the election is still a potential shock and higher government bond yields could at some point compete with credit. These are peripheral at the moment but credit spreads are not really wide enough to suggest that the asset class is cheap. High yield spreads in the US, for example, are back to the levels they were at before the increase in concerns about defaults in the energy sector. Spreads in all credit sectors are much closer to the tights of mid-2014 than to the wider spreads of early 2016 so any hint of a deterioration in fundamentals could push credit returns lower. Let’s face it, we are not at a typical rates turning point where the economy is coming out of a recession and credit fundamentals, having been poor, are recovering. At those times there is a negative correlation between rates (higher) and spreads (lower) but we would be typically starting from much more distressed credit levels than is the case today.
But at some point… – Before I get too bearish though, I should point out that I think there is a limit to how far yields will rise. Global inflation is still low, developed market growth is still sluggish and central banks are still fighting the legacy of the great financial crisis. I think there are vulnerabilities to higher rates – in peripheral Europe for example, or in emerging markets. What’s more, the many central banks are still buying bonds and the search for yield is still the prime motivation for many investors. Pension funds need duration and a 30-year Treasury that is close to yielding 3% again will look attractive. So what I am saying is that I like this sell-off but I think there will be a good buying opportunity in bonds at some point. A gilt yield of 1.8% or above, Treasuries above 2.0%, bunds in the 0.35% area. The case for buying longer duration would certainly be boosted if equity and credit markets start to wobble. But let’s wait for the election, for a couple of higher CPI prints and for the risk-off frenzy to take hold before. The macro backdrop to all of this is that the US will raise rates, that inflation in the UK will go up and that the ECB will continue to keep rates low for as long as possible. In summary it will be hard to get decent returns from bonds until bond yields are higher than they are today. The most bullish scenario for bonds is that the Fed hikes a couple of times, credit spreads sell off and we get entry point valuations that we haven’t seen for 3 or 4 years. That might be the trade of 2017 especially if the US economy has a final spurt in this cycle then slows markedly in the back end of next year.
Big Bang dynasty– Big bang saw the disappearance of jobbers and brokers and saw the beginning of a long period of dominance of financial services by big banks. It’s hard to say how the last thirty years would have evolved without those momentous changes in the City and whether we would have had the various episodes of financial boom and bust. We seem to be on a cycle of more regulation today compared to the politics of deregulation that were in vogue back then. While there are arguably bad things that stem from the Big Bang, to me there are a number of good things as well – the City is more meritocratic, more international and more accessible than it was in the 1980s and before. I doubt even Brexit can fully reverse all of that.