Interest rates globally fail to accurately reflect fundamentals because QE has distorted markets, says our Global Head of Fixed Income. Investors have certainly benefited from the run-up in prices, but how much lower can rates go when over USD 10 trillion in global bonds have negative yields?
Do not be oblivious to the obvious
It would be stating the obvious to acknowledge that current interest-rate levels do not accurately reflect prevailing fundamentals in terms of growth and inflation. Although yields in the euro zone are certainly being driven lower by a growing structural imbalance between savings and investment, the securities purchase programme implemented by the European Central Bank (ECB) is the real cause behind the historic fall in bond rates.
Investors have not been hard done, however, as their portfolios have largely benefitted by delivering surprisingly positive performances. And there certainly have been some surprises. A few years ago, would any reasonable investor have anticipated that in 2016 over USD 10 trillion of global bond assets would be yielding negative rates? Or would any reasonable investor have imagined that one day it would be necessary to pay in order to grant credit to a corporate issuer? In this somewhat irrational world, it is now time to accept that this windfall effect is soon going to come to an end. Past returns have, to a certain extent, already been “pre-empted”, as payback time is drawing near. But when will this be?
Central banks hold the answer
Once again, the world’s central banks hold the answer. The US Federal Reserve, after having struggled so hard to remain inactive, is running increasingly short of valid arguments to defend its unjustifiable position. The full employment situation in the US and a steadily accelerating rate of wage inflation are clearly indicating an imminent increase in interest rates over the coming year. However, given the highly unusual character of the forthcoming monetary-normalization phase, we are anticipating a series of measured rate hikes which will be much more restrained than in previous cycles.
The ECB, on the other hand, has only one option. Despite its tentative comments at the beginning of October regarding the potential tapering of quantitative easing, which was mooted in order to test the market reaction to the idea of progressively scaling back monthly securities purchases, the ECB can realistically only press ahead with its planned programme. It is either that or consider stepping it up, given the low level of inflation in the euro zone.
What are the implications for interest rates? The markets have so far remained relatively immune to the idea of an increase in the federal funds rate. Before too long, however, investor anticipation is likely to be reflected in a flattening of the US Treasury yield curve and in higher long-term rates compared to the current levels. As core interest rates are unlikely to remain unaffected by this scenario, particular attention must be paid to managing portfolio duration.
In Europe, German bund rates are currently pricing in a high-risk environment, including political, geopolitical, macroeconomic and financial risks, which are unfortunately unlikely to abate in the near term. More specifically, key issues such as the future of the euro zone in the context of Brexit, amid a general rise of populism in Europe accompanied by protectionist leanings, are likely to cause nervousness in the markets, which of course will benefit the bund as the ultimate safe haven.
It is therefore becoming increasingly necessary to seek out diversification strategies in order to increase portfolio returns while reducing the overall level of risk, and also to guide investors through this progressively more challenging environment. The only solution, over the course of the next few months, will be to continue providing flexible, proactive and conviction-based asset management.
For more information, read the 4Q 2016 Fixed Income Quarterly
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We expect the ECB to extend its asset-purchase program, buying EUR 80 million in bonds each month, because of concerns about low inflation and political volatility. But Trump could be a wild card in the bank’s plans for continued accommodation.