With regard to the direction of interest rates, it makes sense to look at the UK and US together, given their historically high correlation. They are in similar points in their economic cycles and US rates generally tend to drive the direction of developed market rates. Forward interest-rate markets curves for both the UK and US project increases across the yield curves, with two-year yields rising about 80bps to 1.4 per cent, five-year yields up about 60bps to 2.5 per cent, and 10-year yields up about 35bps to 3.0 per cent.
This bear flattening makes sense when viewed alongside the consensus belief that the Bank of England and the Federal Reserve will start raising rates around the middle of next year, pushing up the short end of the yield curves that these central banks have been artificially suppressing. Longer rates will rise less as their respective economies are not likely to rocket beyond the 2.5 per cent to 3 per cent GDP expectations. All this said, the predictive power of the forward rates market has been shown to be poor. This is especially in evidence during the past few years when intermediate rates continued to trend downward, despite forward markets signalling the opposite.
Data from the past few quarters points to the UK being well on its way to improving growth and employment. Indeed, gains here have been so marked that it caused BoE governor Mark Carney to backtrack on forward guidance regarding the unemployment threshold. The consensus view now appears to be that the BoE will start raising rates next year before the US Federal Open Market Committee.
But caution is warranted here, as it is dangerous to extrapolate recent events into longer-term trends. Though employment is improving, there could still be a considerable amount of slack in the UK labour market, as Office for National Statistics data indicates that current per-capita GDP represents only a 2 per cent gain over the 2008 recession low (versus an 8 per cent increase for the US). The minutes from the BoE’s last few Monetary Policy Committee meetings have revealed that the committee has been discussing whether the self-employed, who have contributed significantly to the growth in UK jobs, are in fact underemployed individuals in search of full-time work. A larger-than-perceived slack in the labour force could translate into lower wage-price inflation expectations, which would help keep a lid on interest rates.
Lower inflation expectations are not the only thing that would cause the BoE to be extra careful with rate increases. The UK housing market will also present a potential challenge. As the Bank rate rises, homeowners with tracker or variable-rate mortgages will feel the pinch as monthly payments increase, taking away disposable income they would otherwise be putting into the economy. This could be meaningful, as retail consumption accounts for approximately two-thirds of GDP. Ostensibly, the BoE will not have to raise rates to control an overheating housing market, as the Financial Policy Committee can implement its new macro-prudential tools to control borrowers’ access to mortgage credit and dampen housing demand.
Finally, the equity market could have the potential to limit a surge in yields. Current equity levels are toppy and a catalyst for a leg higher feels elusive. It is increasingly difficult for firms to widen margins, leaving top-line growth to fuel equity gains. For this to happen, there needs to be sustained validation from the economy (especially capex in the US) before investors will feel compelled to bid levels much higher. Gilts and US Treasury yields are attractive near 3 per cent when you consider that the dividend yields on the Russell Global and 1000 equity indices are 2.5 per cent and 1.9 per cent, respectively. The dividend yield on the FTSE 100 is respectable at 4.5 per cent, but there are fixed income alternatives that multi-asset investors will view as competitive, if not preferable to equity in the current market environment.
UK and US rates over a one-year horizon are likely to head higher from here – but not by much, and the ride will be bumpy as central bank rhetoric/guidance coalesces with economic data and ultimately converges with policy implementation. Current low rates of volatility (the US Treasury MOVE index is running at half its 25-year average) means there is heightened potential for spikes in volatility, with UK and US rates likely to span 2.9 per cent, plus or minus 40bps, over the near term.
‘Known’ sources of volatility are geopolitical stress (for example, Ukraine) as well as election calendars in developed markets: European parliamentary elections this May might result in more seats going to anti-EU parties, which may serve as a harbinger of things to come for next year’s general election in Spain. A vote for Scottish independence this September might cause gilts to sell-off, as investors worry about a smaller UK. In the US, the November mid-term elections could see the minimum wage becoming a campaign issue, fanning inflationary fears. As for the BoE, even though current MPC guidance is that Bank rate increases will not happen until after the May 2015 UK general election, it could come as early as February (coinciding with the quarterly inflation report), should wage pressures push up inflation expectations faster than anticipated.
So, in an environment where rates are generally expected to head higher in a volatile fashion, where should investors look to invest their fixed income allocation?
Active strategies worth exploring include absolute return fixed income funds and duration-hedged share classes of global bond funds. Absolute return funds can include long-short rates and long-short credit elements, which can be beneficial in generating total return regardless of the market environment. Duration-hedged share classes of global bond funds typically use baskets of Treasury futures to minimise interest rate risk. These share classes are good alternatives for investors looking to gain exposure to diversified country and credit factors with minimal downside from rate increases (though there is a give up in yield).
Referring back to the FTSE 100’s 4.5 per cent dividend yield, global high-yield strategies can get investors yields in excess of 5 per cent, with less downside than equities. Though we are past the peak in the credit cycle, corporate credit fundamentals are reasonably strong and defaults can be expected to remain at their current 3 per cent level – versus their long-term average of about 5 per cent – for the foreseeable future. There is little price upside in high-yield credit, but at this point the yield is more reliable than the potential return on equities.
Other credit sectors that are worth considering include US and European securitised debt, as well as bank loans. The upside of these instruments is that not only do they provide attractive yields of around 5 per cent, but many securities here are floating rate, which will provide a degree of natural immunisation should rates start to rise. Because of their illiquidity, most investors will only be able to access them through diversified Ucits funds. Investors seeking concentrated exposure to bank loans and esoteric ABS can do so through Qualified Investor Fund vehicles.
Albert Jalso is senior portfolio manager of global fixed income of Russell Investments
Key points
■ With government bond yields near historic lows, fixed income investors are worried about the prospect of higher rates.
■ Data from the past few quarters points to the UK being well on its way to improving growth and employment.
■ UK and US rates over a one-year horizon are likely to head higher from here, but not by much.
