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Perspectives

Higher yields for shorter time

Kris Xippolitos

By Kris Xippolitos

Head - Fixed Income Strategy

November 8, 2016Posted InInvestments, Fixed Income and Investment Strategy

As we move toward year-end, we remain tactically neutral duration on interest rates in developed markets (DM). Declining confidence over the utility of central bank accommodation and speculation over the potential tapering of monthly asset purchases has pushed global bond yields higher and curves steeper. Moreover, improvements in Eurozone (EZ), UK and US third-quarter GDP data and a sharp rise in global inflation expectations have questioned the necessity of overly accommodative monetary policy. Since July, 10-year sovereign yields within the “Group of Seven” (G7) have moved up 35 basis points (bp).

US Federal Reserve rate expectations have also risen. As we wrote back in July, mispriced Fed expectations were one of the largest near-term risks for longer-term rates. Then, futures markets had implied a zero chance for any Fed rate hike through 2017. Today, the probability of a December 2016 hike is roughly 80% and we see no strong reason for the Fed to delay what is a very modest tightening. As a result, most DM yield curves have steepened and long-dated government bonds have largely underperformed –figure 1.

Higher-yields-for-shorter-time_03

Disclaimer: Past performance is no guarantee of future results.

Despite the recent sell-off, the balance of risks still appears skewed toward higher DM rates. The rise in oil prices have pushed up inflation expectations in both the US and EZ, albeit from extremely low levels. As we approach the one-year anniversary of the low in oil prices, low base effects will likely push year-over-year headline consumer price inflation (CPI) higher still. Additionally, Brexit related UK currency depreciation is also likely to pass through to higher CPI. These issues have been the basis of our overweight in global inflation-linked debt. Indeed, since moving to any overweight in June, US Treasury Inflation-Linked Securities (TIPS) have outperformed nominal US Treasuries (UST) by 175bp, while UK “linkers” have gained nearly 20%.

The European Central Bank (ECB) policy announcement on December 8 will also be closely watched. Though we expect a continuation of ECB balance sheet expansion for some time still, a probable downward shift in the size of monthly asset purchases would likely be bearish for global bonds. Indeed, recent hawkish comments from both the Bank of Japan (BoJ) and Bank of England, may further weigh on investors’ minds.

Despite the near-term risks, we believe the extent of a more meaningful rise in long-dated DM yields will be limited by a persistently bullish macro environment. We have a strong belief that central banks will stick with easy monetary policies, as core inflation measures are likely to remain well-below central bank targets. Even headline inflation should begin to moderate next year, as the low base effects from higher oil begin to fade. Fundamental uncertainty over pending Brexit could trigger safe haven flows, while ongoing negative interest rate policies (i.e. ECB and BoJ) should support lower for longer and flatter yield curves.

Even at higher yield levels, we remain underweight low/negative yielding assets in Japan and the EZ (including periphery debt). We continue to favor higher yielding UST markets and would view a back-up of 10-year yields near 2.0% as a buying opportunity. If the back-up in rates coincides with further yield curve steepening, we would look to take advantage of curve flattener strategies (our core longer-term view). Indeed, in every previous Fed tightening cycle, UST yield curves have flattened – figure 2.

In UK Gilts, we remain on the sidelines as building uncertainty over future growth/inflation has bearish undertones for bond yields.

Higher-yields-for-shorter-time_04

Disclaimer: Past performance is no guarantee of future results.

Bonds are affected by a number of risks, including fluctuations in interest rates, credit risk and prepayment risk. In general, as prevailing interest rates rise, fixed income securities prices will fall. Bonds face credit risk if a decline in an issuer’s credit rating, or creditworthiness, causes a bond’s price to decline. High yield bonds are subject to additional risks such as increased risk of default and greater volatility because of the lower credit quality of the issues. Finally, bonds can be subject to prepayment risk. When interest rates fall, an issuer may choose to borrow money at a lower interest rate, while paying off its previously issued bonds. As a consequence, underlying bonds will lose the interest payments from the investment and will be forced to reinvest in a market where prevailing interest rates are lower than when the initial investment was made.

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