“We’re getting to the point where things cannot stay the same,” says Bill Cunningham, senior managing director and co-head of global active fixed income at State Street Global Advisors in Boston.
He says the ‘new normal’ paradigm advocated by Pimco is a good description of the challenges facing the global economy, but that the phrase is misleading because it assumes the world is in a sustainable pattern.
“The world is not ‘normal’ because the status quo is not sustainable,” Cunningham argues. There are contradictory forces working on Treasury bond markets that will eventually force a change. Although he cannot predict which way things will go, the impact is almost certainly a dramatic increase in interest rates, to the detriment of bondholders.
The current low yields in Treasuries imply very low levels of economic growth. If that is the case for the US, then the stress this will put on its ability to cover its fiscal and household deficits would be enormous.
“I can’t imagine the US would then have access to markets at current yields,” he says. (The 10-year Treasury now yields around 3%.) Such low growth would pose the risk of a ‘double dip’ recession and/or Japan-style deflation, leading to a sovereign debt crisis and therefore a massive credit-risk premium. So the yields of today are not sustainable.
Or, Cunningham says, the US leverages its possession of the world’s reserve currency and its sheer size. Doomsday is delayed because the US is not an island like Japan that can become marginalised; global capital wouldn’t tolerate it.
Instead, the Federal Reserve Bank’s dramatic liquidity-pumping succeeds in lifting the economy; that America goes through a painful but purifying process of restructuring, and its resilience surprises the markets with a healthy dose of inflation and GDP growth. This also leads to higher interest rates, as the Fed returns to a more orthodox monetary policy.
“It’s hard to expect the current balance of moderate growth and low interest rates to be sustainable,” Cunningham says. “It won’t last.”
So how do investors brace themselves if interest rates are going to rise, but without knowing in what environment – one in which investors should take risk, or run for the hills?
SSgA says investors should focus on what they can be more certain about, at least for the short run, and park their money in those investments. In two or three years from now, the outcome of the Fed’s gambit will be clear, and investors will be able to reinvest with more confidence.
For Cunningham, that means corporate credit. True, spreads against Treasuries have come in a long way from their 2009 highs, and investors can’t expect the sort of capital gains enjoyed over the past two years.
But corporate credit, even that of financials, is still attractive relative to Treasuries for the next two or three years.
“Don’t bet on interest-rate directions, because you might get fooled,” he warns. But he likes bank loans: set with floating interest rates, they are a hedge against a rise in US interest rates and against inflation, and offer a nicer yield than Treasuries.
But rates will be volatile, partly as an unexpected result of quantitative easing. For 2011, Cunningham expects rates to remain range-bound but bond prices will be bumpy, as markets react (or overreact) to every short-term piece of news.
He believes the big issue will be US unemployment – if it does not decline, the contradictory stresses behind current levels of interest rates will build faster, with a possible breakdown in the current regime coming by 2012.
If unemployment declines, however, the current ‘unsustainable’ regime could drag on for longer, leaving investors with low rates, high volatility, and plenty of question marks – but delaying the inevitable change to the status quo, not mitigating it.