When doves don’t hike

The Fed is on hold. The market believes the Fed is done and is pricing in a rate cut as the next move. For the moment this is a bullish scenario for markets. Interest rate risk has been significantly diminished and this should encourage bond investors to be less concerned about holding duration. It is also positive for credit given that credit spreads widened and credit assets underperformed last year when the Fed was raising rates every three months. Assets that yield more than the official level of interest rates are in play to perform well in the short-term. However, it won’t be too long before we bond investors are worried about valuation levels again. For now, we should take comfort from an outlook that is characterised by low and stable rates, and still positive economic growth. There are downside risks to growth, but recession risks remain low. Last year is so last year, bonds are back.

Easy now 

At the most basic level, there are three core factors that determine returns from investing in bonds. One is the “carry”, the return that comes from regular coupon payments. The second is the impact on the price of bonds from changes in the interest rate environment and the third is the impact on the price of bonds from changes in the credit risk environment. This week the Federal Reserve confirmed that the chances of interest rates going up again in the United States are close to zero. The statement from the Fed and the accompanying revisions to its own members’ interest rate forecasts suggested that there is still the option to hike again, but this won’t be until next year, if at all. For all intents and purposes, for now at least, the interest rate cycle is over. That is how the market is reading the situation. The interest rate market is now pricing in the next move to be a cut in interest rates. Given that the Fed was the only central bank in an interest rate hiking cycle, the more dovish outlook suggests that there is little risk to global bond performance from interest rates going up. That gives investors a green light to take on duration risk where it is rewarded. The European Central Bank has already told us that it won’t consider raising interest rates until next year. The Bank of England, in my view, will not be able to raise interest rates in the UK unless there is a settled situation regarding Brexit. Globally we remain in a low interest rate environment for a long time, essentially reflecting the fact that we are in a globally low inflation environment. Academic economists will tell us that real neutral interest rates are now lower for all kinds of reasons, but in reality, if inflation was higher, rates would be higher. Given that inflation is barely reaching central bank targets, central banks will continue to be biased towards trying to generate inflation. That means low rates. It may also mean, at some point, more quantitative easing.

How low can you go?

So, the Fed has sent a very bullish signal to investors. The signal is that, although recession risks are low and there are still plenty of positive things to say about the global economy, the pace of growth has slowed by enough to make sustaining inflation at close to central bank targets a much more difficult job. Markets have reacted positively with bond yields falling across the asset class, the most noticeable move being 10-year German government bonds falling to a zero percent yield-to-maturity as I write this note on Friday morning. The US Treasury yield curve has flattened again as the future expected path of interest rates is lowered, and UK government bond yields are flirting with 1%. Government bond indices have been rather flat in terms of total returns so far this year but since the Fed meeting yields have moved lower and Q1 returns are likely to be positive.

Excess returns

As for the credit outlook the fact that rates are on hold is a positive. Rising rates were associated with wider credit spreads in 2018. A more dovish rate outlook should remove some pressure for spreads to widen again. Indeed, this has already been reflected in credit markets with spreads narrowing by 40 basis points (bps) at the global investment grade level and by over 100 bps in high yield markets. I would expect credit markets to continue to post decent performance in the short-term as long as the global economic environment does not deteriorate any more. There has already been a significant outperformance of credit indices relative to government bonds so far in 2019 and with very strong technical factors supporting credit – strong demand with limited net new supply – this outperformance could continue to make it a decent year for bond investors.

Expensive, but for a reason

The obvious question is whether bonds offer good value at these levels? That is always a difficult question to answer. The way I would think about it now is whether the potential return from holding fixed income is enough to compensate for what are the perceived risks. My take on that would be that the risk of a hit to capital from higher rates is now significantly lower, that default risks are not really changed and that the global economic outlook is not so weak as to push credit risk premiums higher. Moreover, I think there is strong momentum in markets that could take bonds to even more expensive levels before something changes and, as already discussed, the supply and demand trends in many markets are supportive There is a realistic scenario that the level of credit spreads in many markets can keep on falling back to levels seen in the first half of 2018. That means potential spread narrowing for 15-20bps in the investment grade credit markets and 50-75bps in the high yield markets. The hard currency emerging market bond index that I follow, the JP Morgan Global Diversified index, is perhaps ahead of the game given that emerging market debt started to recover before developed credit markets, but there is scope at a pinch for further tightening from the current 340bps to perhaps the 300bps area.

Could the Fed reverse?

The risk to this bullish view on bond returns mostly comes from there being another shift in the Fed’s stance. However, the barrier for the Fed to turn more hawkish again seems high so there is real value in the “Fed put”. It would need inflation to pick-up. Even then, there are those in monetary policy circles that suggest a period of above target inflation should be (welcomed) tolerated. A scenario of inflationary expectations running away to the upside does seem rather improbable currently and the way of the world today is that when it comes to potential policy mistakes, there is way more concern about the Fed running too tight a policy than too loose. Still there is the possibility that the US economy continues to operate at full capacity with the labour market tight and wage growth picking up further. That could lead to some reversal in the recent direction of bond yields and may lead to some modest increase in break-even inflation rates in the inflation linked sector. Calling for higher inflation and interest rates in recent years has been a common theme amongst some economists and investors and it has generally been wrong, or only right for a short period of time.

Income or total return?

I was involved in a panel discussion with other bond fund managers this week and part of the discussion was on the ability of bond funds to deliver attractive yields to end-investors. That has very quickly become more difficult. A 4% target yield is out of reach in developed government bond markets and is only just doable in the longer-end of the US dollar investment grade credit market. To get 4% you have to take more credit risk and go into high yield or weaker capital structures. That is fine as long as you understand the risks you are taking. But perhaps investors should think more about total return than just headline yields. I don’t get tired of repeating that one of the best performing assets in 2018 was the 30-yr German government bond which began 2018 with a yield-to-maturity of 1.3% and delivered a total return of close to 10%. Actively managed, diversified bond funds that can hedge interest rate and credit risk and tilt towards the best performing assets, can often deliver total returns that are in excess of the yield. In a world of low interest rates, it is the sensitivity of bonds to changes in the interest rate and credit outlooks that is key.

Reluctant risk on

The current bullishness generated by the Fed is also good news for equities. Year-to-date returns are strong and the highs of last September are not far away for the S&P500. Like credit investors, equity investors can sleep a little more comfortably knowing that the Fed won’t be taking away the punch bowl anytime soon. It is true that we are in a very mature cycle and there are lots of headwinds for earnings, but earnings yields are still very attractive compared to bond yields, with price-earnings ratios below their cyclical peak levels. Yes, there are concerns for a number of sectors and companies and the global economy could actually turn out to be much weaker than is currently evident. Yet, to repeat another mantra, expansions don’t die of old age. Recessions normally come when there is excessive monetary tightening. That is not the case today, with the Fed possibly having peaked at a real interest rate of barely above zero. The best way to participate in this risk-on rally is to be diversified. If you feel reluctant to be bullish on equities or high yield – and who could blame you with Brexit, Trump, populism, and so on - it is worth considering to have some good old, very expensive, but safe long-dated government bonds in the portfolio.

Have a great weekend,

Chris