Head - Fixed Income Strategy
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While developed market interest rate risk remains high, the extent of the recent bond sell-off is likely to prove self-limiting
As with the sharp rise in yields last May, the recent decline in global markets is a stark reminder that if you pull on a rubber-band too tight, eventually it will snap. With developed market (DM) sovereign bond yields reaching extraordinarily low - or negative – levels, price sustainability has frequently been placed into question.
The latest bout of volatility was fueled by inaction at the 8 September European Central Bank (ECB) policy meeting. Indeed, the market consensus expectation was that the central bank would modify its asset purchase program in order to alleviate concerns over bond-holding limitations. Under the current framework, it is estimated that the ECB will run out of German government bonds to purchase – and indeed those of other Eurozone countries – by the fourth quarter. Compounded by similar headlines regarding the Bank of Japan’s own bond scarcity issues, the suggestion of central bank efficacy has been quickly discounted in markets.
Long-dated core DM sovereign bonds felt the most pain, falling 2.5% in price in the days following the ECB announcement. Bond yield curves “bear-steepened”, as 10-year German Bunds moved swiftly back into positive territory. Japanese sovereign bond yields reached six-month highs and prices on 30-year US Treasury debt dropped close to 3.5 points. Similar to the “taper tantrum” in 2013, the markets that dropped the most were the markets that were the most overpriced – figure 1.
Source: The Yield Book as of September 14, 2016.
In our view, the extent of the recent sell-off is likely to be self-limited. We believe the ECB will be more inclined to ease further and extend quantitative easing (QE) at upcoming meetings, while Japan’s disinflation issues will likely argue for a continuation of their large-scale bond purchases. The Bank of England has yet to start buying corporate bonds – the scheduled start is 27 September – and US economic data will likely need to be a lot stronger for the Fed to raise policy rates on 21 September. Indeed, recent US data has been disappointing. Moreover, the rise in US LIBOR due to prime money market fund reform – as we discussed in What’s up with LIBOR? – has already tightened money supply, providing another reason for the Fed to pause – figure 2.
Source: Haver Analytics as of September 14, 2016.
That said, we still believe developed market interest rate risk is high. As we wrote in July, the largest near-term risk to our lower-for-longer view is mispriced Fed expectations. Positive economic momentum – that excludes idiosyncratic risks – could reprice US policy expectations, pushing term premiums and Treasury yields higher. Currently, expectations for a December rate hike are near 50/50. Of course, the largest increase in rates would likely be in shorter-dated maturities, as the yield curve flattens.
Though we still expect core government yields to remain low over the longer term, we take a more neutral approach over the near-term. We prefer higher-yielding US markets versus negative-yielding European or Japanese bonds. TIPS have outperformed nominal Treasury debt over the last 3-months, and we still favor exposure as energy prices improve. Despite supportive central bank policy and technical backdrop, we are still reluctant to chase UK Gilts. That said, any short-term rise in yields should be viewed at opportunistically.
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.