Fears of a spike in inflation, and a sharp hawkish pivot in some central bank messaging, have kept government bond markets very turbulent. Stuart Chilvers, Fund Manager of the Rathbone Ethical Bond Fund and Rathbone Strategic Bond Fund says while uncertainty remains high, some of the repricing looks excessive and that’s creating selective opportunities in gilts as growth risks rise again.
For the second time in just over 12 months, financial markets have been upended by a massive geopolitical shock. This time around it wasn’t a global trade war, but the surprise US-Israeli military strikes against Iran and swift Iranian retaliation across the Gulf region.
Initial optimism that the conflict would prove very short-lived quickly dissipated and was followed by sharp sell-offs and intermittent rebounds, all driven by a constant barrage of headlines and social media posts.
Government bonds are often considered the safest asset class (some even deem them to be “risk-free”). But they’ve been caught right in the eye of this particular storm and have been hit by exceptional levels of volatility.
Moreover, there’s been a lot of dispersion in terms of the scale of moves across different government bond markets and across different maturities.
Different strokes for different folks
To be clear, it makes complete sense for there to be some variance in the behaviour of individual countries’ sovereign debt. The US economy’s energy self-sufficiency makes it far less exposed to the immediate effects of the war.
In addition, the US Federal Reserve (Fed) has an explicit dual mandate to target both employment and inflation. (By contrast, the Bank of England (BoE) and the European Central Bank (ECB) are mandated to tackle only inflation.)
Remember, ahead of the war, there was quite a bit of concern about where US employment was heading (although March’s upbeat US jobs data has helped to ease those fears somewhat).
All these differences came out loud and clear in the messaging we got from the central banks.
Fed chair Jerome Powell presented a very balanced ‘wait-and-see’ approach at the bank’s March rate-setting meeting and talked about looking through the oil price shock, subject to long-term inflation expectations remaining anchored. By contrast, the BoE and ECB were a lot more hawkish.
As discussed, this difference in messaging is understandable given the differences between the various economies and their respective central bank mandates. In addition, hawkish central bank messaging can in itself be used as a tool to try and limit the second-round effects of energy price spikes.
Clearly, policymakers can’t actually do anything to mitigate how higher energy prices may drive up inflation. But by adopting a hawkish tone, and signalling potential rate hikes, they can try to anchor inflation expectations and try to stop steeper energy costs from spreading into a broader inflationary surge.
Markets clearly took note of the hawkish BoE and ECB tone. Ahead of the conflict, markets were pricing in two 0.25% rate cuts from the BoE by the end of the year.
But by one point in March, they were pricing in more than three BoE hikes. Likewise, markets had been expecting the ECB to keep rates on hold this year, but subsequently began to price in three hikes by year-end.
We’ve been somewhat surprised that both central banks and markets have seemed to take a sanguine view of the potential hit to growth as a result of the energy price spike.
Risks of a growth slowdown seem particularly acute in the UK. Growth was already somewhat anaemic before the conflict began and the unemployment rate has steadily trended higher over the last 18 months.
We understand that ‘muscle memory’ may be prompting many to fear a repeat of 2022’s inflation spiral (and we suspect that part of the current central bank rhetoric is aimed at trying to convince consumers and employees not to act in ways that turn their inflation fears into reality).
Moreover, we think there are clear differences nowadays to the 2022 scenario. These include the starting level of interest rates, the softer jobs market and less accommodative fiscal policy. The list goes on and on…
As you would have expected, we’ve seen a significant bear flattening in government bond curves. Clearly, short-dated bonds are most sensitive to changes in interest rate expectations and, as such, have sold off most aggressively.
However, the higher duration of long-dated bonds means that relatively smaller changes in long-term yields translates into significant percentage changes in the absolute value of bonds at the long end of government bond curves.
The last couple of months has delivered a stark reminder that government bond markets are likely to remain more volatile in future, certainly when compared with the pre-COVID period.
But we also think this volatility has opened up attractive opportunities to increase our duration/exposure to gilts.
On balance, we think markets have moved too aggressively in terms of interest rate pricing.
Even if the hikes currently priced in do materialise, we feel that central banks will likely end up having to cut rates further than they might have done otherwise because of the more challenging outlook for growth and employment.
That being said, given the speed and scale of the moves we continue to see, we expect to remain very active in managing our duration exposure.
In particular, we’re expecting investors to resume their focus on fiscal concerns once again.
Potential government policies aimed at helping to insulate consumers from higher energy costs and any possible acceleration in governments’ defence spending might both reignite intense scrutiny of specific governments’ fiscal largesse.
And that, in turn, may drive more volatility across government bond curves.
Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. The writer’s views are their own and do not constitute financial advice.
This information should not be relied upon by retail clients or investment professionals. Reference to any particular investment does not constitute a recommendation to buy or sell the investment.
Main image: question mark, jon-tyson-hhq1Lxtuwd8-unsplash
