Behind the curve?
What do historically low interest rates mean for bond markets and could an anticipated post-pandemic market recovery spur new inflationary pressures? Here, Newton head of fixed income Paul Brain considers the outlook for fixed income investors.
Where next for bond markets? After facing some extreme tests in 2020 as the impacts of the Covid-19 pandemic spooked investors and drove major outflows, Newton head of fixed income Paul Brain says some sense of normality has returned to fixed income markets.
“While bond markets started the year with a bearish tone, partly due to central bank rhetoric, market resilience is good and we are seeing quite a lot of new issuance with companies able to refinance at pretty attractive rates,” he adds.
“Corporate yields are still quite low on an historical basis, volumes are still strong with liquidity being provided to the market makers. Against this backdrop, the market would appear to be in relatively good shape right now.”
For all this, interest rates remain at historically low levels, with central banks continuing to pump a steady supply of support money into markets. According to Bloomberg’s quarterly review of monetary policy¹ major central banks look set to maintain their ultra-easy monetary policies² throughout the year even if the global economy powers back to recovery after last year’s Covid-related trough.
While new coronavirus vaccines bring hope of a gradual return to life as we knew it, Brain is concerned that any rapid economic recovery holds the potential to stoke inflation. He says that as the Covid-19 crisis has unfolded, a key theme that has emerged is a ‘tug of war’ between the deflationary forces of the real economy, where private-sector cash flow and incomes remain under pressure, and the inflationary influence of policymakers’ response to the pandemic. On this, he adds, public-sector balance sheets are now being expanded to new levels in an attempt to limit the fallout.
In this scenario, Brain points to parallels with 1994 when the US Federal Reserve (Fed) was slow to react to rising inflation and failed to prevent a turbulent dislocation in wider markets.
“The danger is that, as in 1994, the Fed finds itself ‘behind the curve’, in winding down unprecedented levels of extraordinary monetary stimulus or adjusting interest rates just as inflation returns,” he says.
“If we get to the middle of the year and find we have a full blown economic recovery and also have inflation levels of 2% or above I think all eyes will be on whether the central banks act on interest rates. If their reaction is too slow we could see renewed pressure on risk assets, a wobble in the equities markets and a resulting fall in bond yields,” he warns.
Source: Bloomberg as at 24 December 2020.
Either way, Brain believes some investors may struggle to make good bond market returns in what could prove a challenging year, with markets facing much uncertainty and where a rise in inflation is likely at some point.
“It has seemed for some time that some of the long-term deflationary trends we have witnessed in recent years may be coming to an end. Demographic trends and signs that globalisation may be going into reverse suggest costs and prices will rise, with a greater emphasis on domestic production of goods in major markets and a return of inflationary pressure,” he says.
“While the immediate deflationary backdrop should prove more supportive for government bonds in the near term, the return potential for many developed bond markets is likely to be limited as yields are close to historic lows. Meanwhile, the potential return of inflation means those investors in bond strategies unable to adapt to the changing backdrop may run the risk of seeing returns eroded over time,” he says.
While Brain does not anticipate any major move in bond spreads in the months ahead, he does see some scope for increased defaults in the high yield credit sector. However, he believes select areas within the emerging market bond universe may benefit from global growth which, in turn, could also buoy segments of the credit market.
“While headwinds for the real economy will persist in the near term given continuing concerns over further waves of the virus and social mobility restrictions, vaccine rollouts reinforce the already improving global-trade momentum and abundant liquidity conditions that could represent a favourable environment for some risk assets,” he concludes.
¹Bloomberg. Ultra-Low Interest Rates Are Here to Stay: 2021 Central Bank Guide. 05 January 2021.