Fixed Interest Review Q1 2016
Unlike the fourth quarter of 2015, the latest quarter under review has seen a sharp fall in bond yields. Central Banks continue to wrestle with the thorny issue that there remains an excess of saving in the world which continues to hamper global economic growth and pulls real interest rates down. This suggests that the need for monetary accommodation is to be maintained for much longer than most investors expected. The beginning of the year has seen volatile equity market conditions and there has certainly been a spill over into both investment grade corporate bonds and high yield. Certainly as conditions have stabilised towards the end of the quarter there has been a sharp recovery in some of the heavily sold off areas, notably local currency emerging markets bonds. The yield attractions have simply been too tempting.
Europe has seen a lot of attention over the quarter, with the concern that the Banking sector and the real economy are deleveraging too rapidly. Bank assets remain vast, approximately 3x the GDP of the region. Headline inflation rates have been in, or have flirted with, deflation in spite of ongoing economic growth and a steady recovery in labour markets. For instance, the headline Consumer Price Index has been contracting at a year on year rate of 0.2% and has been below the ECB target for over three years. An interesting issue is whether this, seemingly, temporary cost-push type of deflation could have a more long-lasting impact on actual inflation and inflation expectations which could, itself, influence consumption and wage-setting decisions. The ECB should be applauded for the recent policies on stimulating the region’s growth with Draghi keen on ensuring future stimulus was delivered through a range of non-conventional channels rather than simply hitting the banking sector.
In the UK, interest rates now look likely to remain on hold well into 2019, indeed money markets are pricing in the consensus to be August that year.Since the hawkish stance of last summer, much has happened to convince markets that rate rises will be further off than anticipated. These events include the equity market turbulence, caused by China, in autumn and again in February; weaker UK economic growth; the return of UK deflation in September (although inflation returned to 0.2pc in December); the plunging oil price; More dovish comments from the Bank of England .The Bank of England Inflation Report on 4 Feb, on so-called Super Thursday, boosted the case for the “doves” and markets pushed the forecast for the first rise further back.
The UK’s cooling economy and slower than expected deficit reduction will lead to a £2bn increase in gilt sales in the coming fiscal year as the government tries to balance the books by raising more debt. Credit investors say any alarm at the increased supply of gilts has been counterbalanced by a reduction in UK growth forecasts and expectations of long-term low inflation, both of which make fixed income assets more appealing.
In the US, the Federal Reserve appears to have become increasingly responsive to changes in financial conditions and indeed the financial markets. Overall, the US economy is resilient however the strong currency and lack of fixed investment remains a drag. The full employment conditions and some pick-up in inflation create the offset and we still feel interest rates will rise over the summer months, although there are likely to be only two rate moves this year rather than the previously estimated four. There are very early signs that investors have started to ratchet up inflation expectations. The bond market in particular is signalling the upward shift in inflation sentiment, which had been battered five weeks ago with domestic oil prices tumbling to 12-year lows. The yield premium on regular U.S. Treasuries over TIPS, known as inflation breakeven rates, has risen from the weakest levels since early 2009 on signs that domestic core inflation is accelerating.
In China, the Central Bank has pledged to make monetary policy more flexible this year even as it leans more on increased fiscal spending and tax cuts to support economic growth and cushion the pain from structural reforms. Manufacturing output, for instance, in January and February grew at its weakest pace since 2008. Investors remain fearful that a devaluation in the Yuan will unleash mayhem on the global financial markets. We feel the authorities are more than aware of this and would find the scenario unpalatable. The Chinese 10 year bond yield stands at 2.88%, virtually flat on the quarter.
There is no surprise that the collapse and volatility in oil prices has injected fear in the US high yield bond market. Debt issued to energy companies make up approximately 11% of the entire asset class. The financial sector has also been weak, as fears of negative interest rates became more widespread. Negative yields threaten bank profit margins as yield curves flatten worldwide and bank NIM’s (net interest rate margins) narrow. We highlighted in the last report the concerns over liquidity in the asset class and these fears will remain. For instance, two high-yield bonds sales in February were only completed after the issuers tightened the covenants significantly, more evidence that the market has reached a turning point. In recent weeks Bargain hunters have been attracted by the rise in spreads over Treasuries, with a high implied default rate priced in.