Is it the end of the bond rally?
The past 10 years have seen bond yields consistently moving lower, and 2016 proved to be no exception. A combination of ultra-accommodative monetary policies and slower growth has pushed yields to record lows in the 4 major zones. Since the US election though, a trend of rising yields, steeper curves and wider credit spreads called the end of this secular rally into question. 10 year treasuries rose from 1.80% to 2.30%, and the Bund now sits above 0.20%, after recording a level of -0.15% in September. The question on everyone’s mind is: “is this the end of the bond rally”? Over the past 25 years, the only periods when the US bond markets posted negative returns occurred at times of rising CPI and/or tightening monetary policies. Therefore, will rising monetary policy and inflation rates lead to a regime-change for bond markets in 2017?
Shifting from exhausted Monetary Easing towards Fiscal Expansion
As unconventional monetary policies were pushed to their limits, undesired effects began to outstrip the positive ones. Although those policies helped contain significant events like the Subprime debacle, the Eurozone Sovereign-crisis, Brexit, etc…, they also limited bank earnings generation and proved unsuccessful in steering inflation and growth back to pre-crisis levels. Now, Japan, the UK and the US appear to be walking the path of fiscal expansion as a means of re-invigorating their domestic growth.
Moving from a long period of Deflation to well supported Reflation
Low yield in a low inflation environment has guided investment strategies over the last 5 years. The deflationary stagnation which has plagued Japan for years has prompted some investors to believe this could spread to other developed economies. However, wage pressures and rising healthcare costs are good examples of domestic drivers of inflation in the US and the UK. Add to the mix rebounding oil prices and a new trend of protectionism, and you may have a recipe for higher yields. In this context, we expect the FED tightening cycle to be underway with a minimum of 3 rate hikes over the next 12 months and the ECB to consider tapering during H2 2017.
Ready for a New Bond Regime with differentiation and selectivity
The combination of monetary tightening and firmer inflation will propel fixed income markets into a new regime. Expect more volatility. But as this new paradigm will lead to dislocations, it will also bring opportunities in bond markets, requiring flexibility and selectivity. Opportunities continue to be present in an increasingly fragmented universe, and we aim to exploit them through a focus on carry-to-risk as well as low correlation with US Treasuries. High carry opportunities will persist in EM Local and external bond markets, although selectivity and relative value will be key. Specific sectors such as European Financials also offer an interesting profile, benefitting from strong fundamentals and a bond friendly regulatory environment. Finally, inflation linked bonds are an enticing proposition in a reflationary environment and should represent an important pillar in all bond portfolios.
