Yields up, ready for a pause
It is always rather intriguing to watch how investment flows respond to market events. Bond yields have risen (after many forecast that they would for a long time) so bond funds have seen negative returns and money has flowed out of the sector. Today yields offer the best value for some time. However, they are likely to move higher in time as the US economy roars ahead on the back of more fiscal stimulus. In the short term investors can find some nice opportunities in fixed income. High yield is actually looking like “high yield” again while the emerging market bond story is good. Risk on in equities will support higher beta parts of the bond market. However, the rates outlook remains the key.
It is interesting to note, albeit based on anecdotal evidence, that investors are moving money out of fixed income funds in response to higher yields and negative returns. Flows do tend to follow performance. This is not entirely logical but it does highlight that risk aversion is highly correlated to volatility. When bond yields were very low and stable, there was no evidence of investors reducing their fixed income exposures. Now that volatility is rising and yields have moved higher, there are outflows. It is not clear where the money is immediately going but the flows do suggest that, at least based on behavior, investors think things will get worse before they get better in bond-land. As I write, the 10-year benchmark US Treasury yield is closing in on 3%. This is the highest level since the beginning of 2014 and represents a 160 basis points (bps) increase in yields since the low reached in mid-2016. The pattern, if not the actual size of the move or the level of yield, has been the same in the German bund and UK gilt markets. It might be that investors are getting out of bonds a bit late.
Outflows from bond funds are coming when there is certainly more value in the market than there has been for some time. Government bond yields, as noted above, are up more than 50 bps in the US, year-to-date (similar moves in gilts and bunds). Investment grade corporate bond credit spreads are more or less unchanged, year-to-date, but have widened in the last two weeks in response to higher equity market volatility. So yields on investment grade bonds in the US, Europe and the UK have not moved to any greater degree than government bonds. However, on the high yield markets there has been more of a re-pricing with the US market now yielding 100 bps more than it did in early January. For long-term followers of US high yield, that benchmark yield is now back above 6% for the first time since the end of 2016. European high yield bonds have not seen such a large move but the benchmark yield is back above 3%. I doubt that these yields are enough to entice investors back into fixed income just yet, especially when sentiment is bearish and expecting higher yields as we move further into the regime of monetary normalisation. Indeed, the risk scenario is now not about being “short” but about being “long”. Investors have to take on board the risk that the global growth may stay strong, inflation will rise further, the Federal Reserve (Fed) will not be done at 3% and the term premium will rise meaning longer-term interest rates will need to offer a higher potential risk adjusted return. Put it this way, if the current spread between the 10-year yield and the Fed Funds target of 140 bps is maintained and the Fed raises rates by another 100 bps this year, then we are looking at yields of close to 4%. Yes, the yield curve will probably flatten as the Fed tightens further, but that entirely depends on what happens to growth and inflation expectations and the demands on the market from increased Federal borrowing. Those that have wanted to be short the market in recent years and have suffered as a result of yields moving lower, I genuinely think that this time is different. There is no “buy on dip” mentality in the bond market at the moment. There is more of a “sell on strength” approach. That can change quickly, but it also means the risk is to yields going higher.
Calling the top (or bottom) in bond yields is not easy or very useful. However, seeing the value of bonds in an overall investment strategy when yields are significantly higher than a year ago is worthwhile. If multi-asset investors are concerned about the recent increase in equity volatility, they should perhaps consider the hedging role that bonds can play. For example, in the UK, 30-year gilt yields have risen from 1.7% in December to 2.05% today. The benchmark 30-year issue (1.5%, 2047) currently has a yield to maturity of 2.04%. Given a duration of 23.5 years, a 50 bps rally in that bond in response to a period of equity weakness would give a price appreciation of almost 12%. Over a year, that means a total return of more than 14%. The fact that yields have risen perhaps makes it more likely that they can fall again in a stressed market.
It really is a macro market. When I first started in this business, the Fed played a huge role in setting market expectations. Back then (the mid-80s) there was no such thing as forward guidance or published minutes. Market participants had to try and decipher the Fed’s policy stance by analysing the daily open market operations to see if it was trying to get interest rates higher or lower. But it’s almost come full circle in terms of how important it is what the Fed does in the next year as to how investment returns will shape up. Recent economic data has tended to push forecasts of interest rates, growth and inflation higher. Yet recent market volatility means there is more uncertainty as to where market prices end up. You could make an argument for 10-year yields in the US being at 4% or 2% by year-end depending on how quickly the Fed raises rates, what happens with balance sheet reduction and Federal borrowing and how inflation evolves from here on in. What must be something of a central view is that the Fed raises rates by 100 bps this year, the yield curve flattens to some extent, yet 10-year yields still end up closer to 3.5% than 3.0%. That is even without any really wild economic forecasts. If growth resumes close to 3.0% after a softer Q1 and core inflation settles above 2.5%, then we have a situation where the market could expect 2019 to also see more Fed hikes and a bond yield close to 4%. So, for what it’s worth, my short term expectation is that yields could dip a little after such a big move, but then ultimately move higher.
For a while I’ve avoided saying anything about the UK. That’s because everything revolves around Brexit. Even though everyday life has hardly changed, there is still so much noise around the subject. Newspapers, television news and radio talk shows are full of radically opposed opinions on customs unions, immigration, European citizens’ rights and transition periods. Brexit is happening but no-one quite knows what that means. The Bank of England (BoE) can’t give an economic prognosis without being criticised for being too “political”. Commentators and politicians react badly to the publication of the results of economic models of the impact of Brexit that, anyone should know, are only likely to be as (in)accurate as any economic models. International companies don’t want to leave the UK but have no idea how to plan for future trading arrangements. And in terms of investing, who knows what it means? What we can be sure of is that the BoE is not likely to change interest rates enough to have anything like the same effect on the gilt market as the global situation is having. Gilt yields are higher since the start of the year but this is not because of anything to do with Brexit and is almost entirely due to the stronger global growth outlook and signs of inflation in the United States. So the best way to play the UK market is to ignore Brexit for now. Rates are going up a little, bond yields are beholden to what happens in the States and the economy and the corporate sector are doing fine for now. Don’t watch Question Time or read the newspapers.
Around the world
Emerging market fixed income has seen an increase in volatility just like in other sectors. However, I remain a fan of this asset class because of the generally higher level of yields available, the diversification opportunities across regions and countries, sectors and issuers and the improved narrative around the macroeconomic and political situation in much of the emerging market world. Dollar spreads are wider by close to 10 bps year-to-date and only by around 30 bps from the lows at the end of January. The fact that the dollar remains somewhat weak but commodity prices strong is supportive of emerging markets, as is the generally buoyant nature of global trade. The re-pricing in the bond market creates some good opportunities. One market that has benefitted from some good news is South Africa which saw the resignation of Jacob Zuma this week. Both the South African rand and the local bond market have been strengthening in recent weeks in anticipation of Zuma stepping down and allowing a more constructive political environment to emerge in the country. On the dollar side, 10-year bonds yields are more than 5%, almost 50 bps higher than recent lows. While all emerging market dollar bonds are subject to duration risk from higher yields in the US Treasury market, spreads are wider and this provides some interesting opportunities, especially if Treasury yields are topping out for the time being.
For emerging and developed economies, the growth outlook remains pretty good for this year. Many economists have revised higher their US GDP forecasts on the back of the recent budget deal. The Trump Administration also wants to increase infrastructure spending, possibly funded in part by higher gasoline taxes. The Trump reflation is in full swing. While the received wisdom is that Jay Powell, as the new chair of the Federal Reserve Board, represents continuity from Janet Yellen this is somewhat of a dangerous view to take. Yellen tried for years to understand why inflation was so low and had to keep rates low and policy supportive because of that. Now, inflation is rising (CPI up 0.5% on the month in January and 2.1% y/y) and real rates are still very low. Powell may end up raising interest rates by more than what was expected under Yellen because he may have too if the US economy, boosted by fiscal policy, starts to overheat. Markets may be pausing for breath here, but bond yields will still rise further over the course of the next year or so, in my opinion.
I’m not sure that I should say anything about football anymore given another disappointing result for Manchester United last week. Wins by some of my other favourite teams (Sheffield Wednesday, Celtic and Real Madrid) have softened the disappointment somewhat. However, for some reason, United just don’t seem to have a similar kind of mojo that Liverpool and Spurs currently have and, as such, are at risk of losing their position of second in the league. If Jose Mourinho is to stay around for some time, he needs to continue to rebuild his squad, with defence being a priority. There is still a lot to play for this season but the Reds need to up their game.
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