It’s been a 30-year long party, but fixed income professionals believe the world could soon be suffering a nasty and multi-year hangover.
If there’s one thing bond specialists agree on about 2017, it is that investors are failing to price enough inflation into expectations. Some believe inflation is already starting to drain the punchbowl dry, but it seems many guests have yet to realise it is time to go home.
How should investors re-adjust their investment strategies in this new world that appears to experiencing a fundamental shift from monetary policy to fiscal policy as the hoped-for engine of global growth?
Over the next week AsianInvestor will run a series of articles examining the profound implications that inflation may have on global bond markets, which have become used to years of outsized returns. Figures produced by JP Morgan Asset Management, for example, show that global high-yield debt has been one of the best performing asset classes of the past decade, returning 129.5% on a cumulative basis.
Today we start with US Treasury yields, the linchpin to almost every underlying asset class. Key to their performance will be the interplay between a previously dovish and cautious Federal Reserve and an unpredictable new president who will be in place from this coming Friday, in the form of Donald Trump.
James Bateman, global chief investment officer of multi-asset at Fidelity International, was forthright about what was likely to come. He told AsianInvestor: “Markets have been driven up by monetary policy easing the likes of which we’ve never seen before. But I think the unwinding will be a multi-year process, so I’d caution value investors not to re-enter the market once they see US Treasury yields correct in 2017, possibly by about 10%.”
Rate rise expectations
A quick straw poll of banking sector outlooks suggests most houses believe the Fed will raise rates two to three times in 2017, leading to 10-year yields around 3%. However, many analysts were wrong-footed in 2016 when rate hikes failed to materialise as quickly as expected and 10-year yields fell from 2.2% at the end of 2015 to 1.35% in the space of seven months.
Are Treasury yields behaving like a lifelong smoker who finds it takes a couple of times to quit, or will 2017 be another year when yields unexpectedly fall rather than rise?
Jim Cielinski, global head of fixed income at Columbia Threadneedle, agreed that Treasury yields could well compress again given the level of global uncertainties. But the bottom is capped, he argued, and Treasury bonds may deliver zero to -2% returns in 2017.
“One of the most important messages for investors this year is not to get anchored by what they’ve seen before,” said London-based Cielinski. “Even if growth and inflation do not grow as quickly as expected, 10-year yields will not slide back to the 1.35% level again.
“We’re in a new world now,” he continued. “We’re re-knitting the social and trade fabric of the past 30 years, so the drivers are fundamentally different.”
But while many conclude that US Treasury yields have bottomed out, they also argue the shift upwards could be prone to bouts of extreme volatility.
“Markets will swing between euphoria and depression more quickly,” said Cielinski. “They’re unsure how the Fed will respond to rising inflation. That uncertainty is compounded by the fact that no-one knows what Trump’s going to say on any given day, let alone do.”
Twitter tantrum coming?
Does this mean the market’s taper tantrum – the bond sell-off in response to a Fed move to pare back quantitative easing – of 2013 will be eclipsed by an even larger sell-off thanks to a Trump Twitter tantrum? Could this spread to other asset classes, creating a vicious downward spiral?
That is Bateman’s fear, although he said it was not his base case. “If a Treasury sell-off spills over into equities, that could prompt banks to divest stocks under new regulations introduced since the  global financial crisis.”
He was presumably referring to regulations such as the Volcker Rule and Basel 3, which either forbid investment in or make it more expensive for banks to hold certain riskier assets.
“This is what concerns me most,” added Bateman. “Forced selling by banks compounded by a lack of bond market liquidity beyond the Treasury market.”
Does this mean investors should consider going risk off? Not yet, said Cielinski and Bateman, but perhaps in a year’s time.
“This is when we might approach the point when life starts to feel quite difficult,” Cielinski noted. “By then it’ll be clear what impact Trump’s policies are having on growth and inflation.”
However, markets are far better prepared for rate rises now than in 2013, said Ludovic Colin, head of global flexible fixed income at Vontobel Asset Management. If there is heightened volatility, he said the root cause was more likely to be the result of a trade war between the US and China: one that China could not win, given the current trade imbalance between the two countries.
Fiscal expansion fears
A second big concern – on top of general uncertainty over US policy – is the impact of Trump’s proposed fiscal expansion. Vontobel’s Colin said the US did not have much room for fiscal expansion, given that the country’s debt doubled to $20 trillion during Barack Obama’s presidency.
Ben Luk, global market strategist at JP Morgan Asset Management, also highlighted America’s 3% fiscal deficit and government debt to GDP ratio standing at around 100%.
Both Luk and Colin noted that Trump’s fiscal expansion was coming at a very strange point in the economic cycle, since fiscal stimulus was usually deployed when a recession felt imminent.
“Relatively steady growth at a time of near full employment followed by fiscal stimulus could create an inflationary shock as wages rise,” said Luk. “Rate rises could be faster than many anticipate.”
That said, argued Bateman, “inflation of 4% to 6% in the US and UK would be no bad thing, given what we’ve experienced over the past 10 years. My guess is that central banks will view this as a small price to pay for the growth we need to make up for [from] that lost decade.”
Like Vontobel’s Colin, he does not think the Fed will respond to inflation with aggressive rate hikes.
Ultimately, the widespread hope among investors is that the Fed will have taken note of what happened in the 1980s, when the central bank responded to then president Ronald Reagan’s fiscal stimulus with rate rises, which plunged the US economy into recession.