The great debate on when the US Federal Reserve Bank will make that first move towards normalising interest rates will last a little longer.
Forward guidance is out, and the removal of the word “patient” from the Federal Open Market Committee statement following its meeting of 17-18 March gives the Fed the flexibility to raise rates whenever it decides the time is right. But not everything is going to plan. There is more slack in the US labour market than first thought, and the stronger dollar is impinging on export growth. This does not mean that rates will not move up this year – only that they may not move up as soon as the market had been expecting.
Any financial textbook, or Investopedia, will tell you that the fixed income market should be the area most affected by a central bank raising rates. Historically, as the official policy rate has increased in the US, so have the yields on bonds across the Treasury curve – the short and long ends. During the last three rate-hiking cycles in the US, the yields on two-year and 10-year government bonds moved in almost perfect harmony with each other. However, as ever, past performance is no guarantee of future returns, and the US government bond market will likely behave differently this time around.
The massive stimulus measures undertaken by the central banks since the great financial crisis have distorted bond markets, making history an unreliable guide. Meanwhile, the unpredictability of bond markets may be exacerbated by the divergence in global growth and central bank policy. The European Central Bank and the Bank of Japan continue to expand their balance sheets, hoovering up billions of dollars of bonds each week, while the Bank of England and the Fed are contemplating when might be the right time to pull the trigger on higher rates.
So, if we do not expect history to repeat itself, what do we expect? The yield curve can be split into the short end and the long end, or two-year and 10-year maturities. The short end is much more in tune with central bank policy and sensitive to rate moves, while the long end has become more international and influenced by global trends.
This relationship, and how the relationship has changed, is shown in this week’s chart. The changes in the yield in 10-year bonds in Germany and the US are highly correlated and fairly stable. As the ECB pursues its quantitative easing programme and pushes yields down further, these lower yields can be exported globally and constrain the longer end of the US yield curve. Meanwhile, there is no correlation between yield changes in two-year bonds.
If shorter-dated maturities start to rise on the back of higher policy rates, the yield curve will flatten as the longer end rises by less. This particular combination is known as ‘bear market flattening’ of the yield curve, in which the short- and long-term rates start to converge. However, this will not go on forever, and short-term rates should eventually pull up the long end of the curve. The Fed would not want the yield curve to flatten, or even invert, as this would suggest no inflation – and hence economic growth – in the future.
Tightening of monetary policy will extend beyond just government debt and could negatively affect both investment-grade and high-yield corporate debt. For the riskier high yield, an upward move in interest rates should be taken as a sign of an improving economy. And it is an economy in which corporate profits are on the rise and default rates remain low, providing a bit of a cushion to the negative impact of higher policy rates.
For bond investors, a move to higher rates may not be the calamity once feared since the excessive demand created by central bank policies will continue to support fixed income markets. However, given the very low yields on offer across the fixed income spectrum, it will be more important than ever to take a selective approach when allocating to different fixed income positions.
Kerry Craig is global market strategist of JP Morgan Asset Management
