Turning point for bonds?
18 July 2017
Volatility, particularly in bond and currency markets, has picked up of late. Miton’s Anthony Rayner looks at the market influences driving that movement.
Despite muted inflationary pressures, we’ve observed a change in the “forward guidance” from a number of central banks. It’s not clear whether it was coordinated or not, but it certainly feels like more than just coincidence.
These recent communications have seen markets bring forward their expectations of interest rate rises for most major central banks and, unsurprisingly, saw a sell-off in bond markets. This has also been felt across equities: utilities, consumer staples and healthcare (the so-called equity bond proxies) have sold-off, while financials and, to a lesser extent, materials and energy have benefited.
So, why the change in tone?
Central banks want to be seen as data-dependent so it’s worth looking at the data they’ve monitored traditionally. Generally, global growth remains strong, though there are some signs of softening at the margin. Turning to inflation, it remains pretty benign in the major economies, whether we look at the hard data, the soft (survey) data, break-even markets or commodities (we are assuming for now that the majority of the pick-up in UK inflation is a temporary response to a much weaker sterling). Meanwhile, unemployment rates generally remain low, or improving, but wage growth is still not at, or anywhere near, levels that would worry inflation watchers.
We have long argued that central banks, led by the Fed, are keen to raise rates opportunistically, partly to reduce the potential for capital misallocation. It might be that a robust growth environment, if not the inflation environment, provides some cover for this move but, perhaps more importantly, financial conditions are easier, with equity markets higher, credit spreads tighter and, in the case of the US, the currency a fair bit weaker.
Markets are always sensitive to changes in interest rate expectations, not just sovereign bond markets but corporate bonds and equities too, particularly relative to equity sector performance. This time around, however, bond markets have been in a thirty year bull market, global debt levels remain material, central bank rates are at or close to multi-year lows and many central banks have a material amount of their bond market on their balance sheets. Plus, valuations are much more challenging than they were around the 2013 ‘taper tantrum’, when the market panicked over the Fed’s announcement on tapering its bond buying programme. In this context, recent central bank communications are understandable and probably designed to test market resilience.
Nevertheless, risk of policy error is high and markets have flipped quickly between worrying about whether central banks are behind the curve or ahead of the curve. Indeed, it might be that markets have ‘over interpreted’ recent communications. Either way, volatility, particularly in bond and currency markets, has picked up of late.
Our view for some time has been that if we get an environment of decent growth and gently rising interest rates, which is our base case, it should be fairly positive for equity markets, especially for the cyclical growth areas. In corporate bonds, we continue to keep away from long duration issues, to reduce interest rate risk, and instead favour taking credit risk but remain at the good quality end of the spectrum. As usual, the vast majority of our currency exposure is hedged back into sterling, as we don’t want currency risk to dominate our overall risk. In short, we are weathering these events pretty well but remain alive to the high sensitivity of markets.
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