This time of year is fertile territory for TV obsessives. There is The Great British Bake Off, The Apprentice and an endless array of gripping dramas, to name but a few. Meanwhile, over in the investment world, the focus remains on central bank balance sheets.
The time has come for central banks to tighten monetary policy and for the US Federal Reserve to reduce the size of its balance sheet. Investors in government bonds have experienced an extended bull run of over 35 years as yields have trended downwards since the 1980s, as can be seen from the chart below.
The juicy 8 to 16 per cent government yields of the 1980s are well and truly behind us: we now live in an environment of ultra-low yields: currently 0.1 per cent on Japanese bonds, 0.4 per cent on German bunds, 1.4 per cent on UK gilts and 2.3 per cent on US Treasuries.
Balance sheet shrinkage
The US will begin shrinking the size of its balance sheet this month and is expected to raise interest rates by 0.25 per cent before the end of the year, followed by a hotly debated number of further hikes next year. In Europe, the European Central Bank (ECB) will begin tapering its bond-purchasing programme, and is expected to stop expanding its balance sheet by the end of 2018. In the UK, the Bank of England is expected to raise rates at the next meeting of the monetary policy committee in November, with the market pricing a roughly 80 per cent chance of a hike.
This creates an environment in which financial conditions will tighten over the coming years. This presents a significant challenge for bond investors, as it seems clear that the gradual withdrawal of large price-insensitive buyers in the form of central banks should put upward pressure on bond yields, as net supply in government bond markets is set to increase significantly. These are the primary reasons we do not favour government bonds in the fixed income space versus credit and other spread products that have less interest risk.
Ten years after the start of the financial crisis, most of the world’s economies have returned to synchronised growth, near-term deflation risks are diminishing and economic indicators suggest that this trend is likely to continue for some time.
The US yield curve normally flattens as the Fed raises interest rates, but quantitative tightening could dampen this usual pattern and potentially even cause the yield curve to steepen, at least initially.
Steeper yield curve
As the ECB reduces quantitative easing, the European yield curve should steepen. This could lead to a period during which duration performs less well than credit assets, which are better able to withstand a climate of rising government bond yields, owing to their higher coupons and/or shorter maturities.
The seismic shift in monetary policy under way makes it clear that it is more necessary than ever to move away from bond benchmarks, the duration of which has only increased in recent years. That is not to say investors cannot find opportunities in the fixed income market. But, as during the latest episode of sudden yield increases in 2013, investors will need to focus on fixed income asset classes that have a low correlation with long-term government bond yields and whose higher coupons can help cushion the impact of increasing government bond yields on total returns.
