Elon Musk is no longer the world’s richest person and, while his dwindling billions may be making headlines, the source of the commotion is fixed income markets.
Real yields are rising as markets start to fret over the potential for inflation. Is the ‘lower for longer’ interest rate trade finally coming to an end?
The year has started badly in fixed income with yields rising and prices tumbling, particularly in higher quality bonds.
The US 10-year treasury has seen yields rise from 0.9% at the start of the year to 1.4% today, while the 30-year has gone from 1.65% to 2.2%. Similar moves have been seen across the world.
The UK 10-year gilt has gone from 0.2% to 0.7% since January.
More important, says BMO chief economist Steven Bell, is that real yields (government bond yields less inflation) are rising: “Real yields rose over 20bps for 10-year Tips last week, the US equivalent of index-linked bonds. This is one of the biggest moves on record in a single week.
“Even though bond yields rose last Autumn, real yields stayed low. Now that’s changed.”
Negative real yields support risk assets, particularly those expected to deliver strong earnings in the distant future – such as the technology sector.
This is why the share prices of the highest growth technology companies have been sinking in recent days and why Musk may have to put that Learjet on hold.
Selective repositioning
In fixed income, the pain has been felt most strongly in the US and in long maturity debt.
As of 23 February, funds in the FO Fixed Income EUR Long Maturity debt sector are down by an average of 10% since the start of the year, according to Trustnet.
EUR investment grade corporate bond funds are down an average of 4.7%, while EU – high yield is down just 2.7%. More flexible funds have done better.
There are signs that fund managers are selectively repositioning.
The BlackRock Investment Institute said this week: “We have downgraded government bonds to underweight on a tactical basis, with an increased underweight in US Treasuries.
“We also downgrade euro area peripheral bonds to neutral, as peripheral yields have fallen to near record lows and spreads have narrowed. We downgrade credit to neutral on a tactical horizon, as spreads have narrowed to historical lows, but still like high yield for its income potential.”
BII’s reasoning is that while central banks are likely to keep interest rate low, the huge fiscal impulse and rising inflation is likely to drive up nominal yields and may undermine markets’ faith in the low rate regime.
In other words, it doesn’t matter if rates stay low, if inflation expectations rise it can damage the bond market anyway.
Head for the exit?
Does this mean European investors should be backing away from fixed income?
Not necessarily, says Didier Saint-Georges, member of the strategic investment committee at Carmignac.
This is primarily a US phenomenon, where money supply growth has been strongest, the vaccine rollout has been particularly successful and stimulus packages most generous.
He adds: “Inflation expectations remain very tame in Europe, even including the strong base effect that could impact inflation prints […]. Money supply hasn’t taken off in the same way in Europe or Japan. Concerns on overheating are focused on the US.”
He says there are three reasons that this may signal a ‘regime change’ in US fixed income markets.
The first is that inflation is correlated with money supply and money supply has been rising sharply; secondly, inflation is rising from a low base and finally, the US administration’s programme on minimum wages is likely to raise labour costs over time.
That said, where the US leads, Europe may be forced to follow and to date, there has been no discernible gap between the rise in US rates and those in Europe. Saint-Georges believes that Europe will see less inflationary pressure, but still merits caution: “There should be opportunities for alpha generation on the credit side,” he adds.
Protected hedges
Equally, central bankers may step in if the rout threatens to destablise markets more generally.
Christine Lagarde, president of the European Central Bank, said that it is “closely monitoring” the situation.
Its apparent willingness to act temporarily halted the sell off in bond markets, though it has subsequently resumed.
It is worth noting that the current reflation trade has some considerable risks. It would only take relatively small disruption to the supply of the vaccines to derail the current economic reopening strategy. Consumer spending may not bounce back as expected, while the jobs market also remains fragile.
Confidence data from SMEs is still relatively weak. As such, investors need to be prepared for relatively binary outcomes.
Richard Hodges, manager of the $3.36bn Nomura Global Dynamic Bond Fund, showed the tricky balancing act for many fixed income managers in this environment.
“In the short term, we are content to balance the riskier allocations within the portfolio – cyclically biased high yield exposures, industrial names within convertibles, subordinated financials debt, selected emerging markets – with protective hedges via equity put options and a large allocation to short-dated US Treasuries.”
These are tricky times in the fixed income market and the fact that many knew they were coming will be little consolation. It appears that the ‘lower for longer’ interest rate trade may finally be drawing to a close, but there are risks on both sides.
