Fixed Interest Review Q3 2017 – All eyes on the Central Banks..
Once again, the last quarter under review has seen global bond market sentiment dominated by the actual and crucially, the intended actions of the Central Banks. As the period has progressed, investors have been surprised that the tone has become far more hawkish. Balance sheet normalisation is one of the main priorities. We would question why many investors should have been caught off guard, the US and the UK economies are both running at virtually full employment, and there could easily be overspill into wage negotiations. The Bank of England have added woes with the weaker currency boosting short-term inflation.
US ten years yields are actually little moved on the quarter, with 2.3% at the end of June 2017 and they made a low of 2% in early August. They have since risen back towards the 2.3% level as the Federal Reserve have made it clear that the next interest rate rise will come in December. Investors should also be prepared for a number of upward moves next year, although interestingly we now have an insight into the perceived finishing point.
The new dot-plot of Federal Reserve officials’ projections showed a quarter-point reduction in the median long-term estimate for the benchmark, to 2.75%.That is a substantial two and a half percentage points below where the target was before the global crisis began a decade ago. Janet Yellen has also long been planning to reduce the size of the Federal Reserve balance sheet and sure enough, there was more detail on this in the recent meeting. The process of reducing the $4.5 trillion balance sheet would start in October, the Fed announced, leaving it to run steadily into the next decade. It is estimated that in three years, it should have reduced to $3 trillion in size.
There is still some surprise at the low level of US inflation with some observers highlighting that structural drags on inflation from technology may be countering the normal cyclical forces that ought to drive prices higher. There have been some temporary factors leading to a higher inflation spike, notably energy prices as a result of the exceptional hurricane activity this year. On a twelve-month view however, the Federal Reserve believe that inflation will drop below 2% before in the medium term moving around the 2% target level.
In the UK, the ten-year yield ended the second quarter at 1.26% before declining in the early part of the third quarter to 1%, however in recent days it has risen sharply to nearly 1.40%. We would welcome the view from the Monetary Policy Committee that interest rates need to start rising. It is clear that despite Brexit concerns in the background, the domestic economy is in strong enough shape to handle a gradual withdrawal of the monetary accommodation. While the first rise may simply serve to reverse last year’s emergency rate cut, there are signals that the Bank may then push still further ahead.
Criticism in recent years has been levelled at the very short-term reaction the Bank seems to have to key data points. Many observers have called for a clear, long-term strategy for raising interest rates and unwinding QE over the next two-to-three years. This should be focused on bringing the interest rate up to 2-3 per cent, in line with or just above the inflation target. In the absence of big shocks to the economy, the MPC should then stick to its plans.
In Europe, the economy continues to be very strong with manufacturing confidence close to all-time highs. As with many other economies there still appears to be little to worry about on the inflation front. Bond yields across the region are little changed on the period and we would question just how appealing a French ten-year issue is at 0.75% yield to redemption. Even though the ECB is looking to taper bond purchases, it will probably take until 2020 for the actual reverse of Quantitative Easing to take place.
Overall, credit spreads have remained close to the lows in the wake of the credit crisis and this should not be a surprise given the broadly supportive conditions. The oil price has also continued to rise, which has eased conditions in one of the most embattled sectors. According to U.S. data company Dealogic, some $340 billion of high yield debt has been issued year to date, which is a 38% increase on a year ago. Given the level of overvaluation in high yield, it has become evident that investors are shifting assets to Emerging Markets bonds.
Emerging-market debt is by no means cheap relative to historical norms, but it pays higher yields currently, but as ever, we need to consider the risks. High foreign ownership of local-currency debt markets is setting them up for a hard landing if global monetary policy tightens more than expected. The relative weakness of the US $ has also encouraged the shift; if this was to reverse there would also be an outflow from EM assets.