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Delivering income
Fixed IncomeOct 4 2017

Bond investors face a tightrope of uncertainty

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Bond investors face a tightrope of uncertainty

The main issue the bond market faces over the coming 12 to 18 months is that central banks across the world are expected to increase interest rates and at the same time move away from the decade-long unorthodox monetary policy of quantitative easing (QE).

At its most basic, QE involves central banks expanding their balance sheets by creating new money and using it to buy bonds, pushing up prices – and reducing yields – in the process.

Of the world’s central banks, the US Federal Reserve (Fed) is furthest along in terms of the economic experiment of quantitative easing as a policy tool and following its meeting in September 2017, the Fed's interest rate-setting panel, the Federal Open Market Committee, firmly signalled that a December quarter point interest rate rise is still on the table and that the interest rate projections for next year remain largely unchanged with three quarter point rises envisioned in 2018.

The Fed did, however, slow the pace of anticipated monetary tightening expected thereafter forecasting only two quarter point interest rate increases in 2019 and one in 2020. The Fed also lowered its estimated long-term neutral interest rate from 3 per cent to 2.75 per cent, reflecting concerns about the overall economic potential for the US economy.

As far as quantitative easing goes the Fed, as was widely expected, said that from October 2017 it would begin to reduce its $4.2trn (£3.1trn) in holdings of US Treasury bonds and mortgage-backed securities by initially cutting up to $10bn each month from the amount of maturing securities it reinvests.

Key points

  • The next 12 to 18 months are going to potentially be very challenging for bond investors.
  • So far markets have been unperturbed by the prospect of the Fed increasing interest rates.
  • Many investors fear heightened volatility as central banks change course.

The Fed ended formal quantitative easing in 2014 as the economy strengthened, but has since kept its balance sheet high by reinvesting the proceeds of existing bonds as they have matured. The limit on reinvestment is scheduled to increase by $10bn every three months to a maximum of $50bn per month until the central bank’s overall balance sheet falls by $1trn or more in the coming years.

To be frank, to date, markets have been unperturbed by the prospect of the world’s most powerful central bank increasing interest rates and reversing quantitative easing. US economist Janet Yellen has predicted the process will be as uneventful as watching paint dry, although a cynic might think she would say that.

Unfortunately an issue for some is that there is no agreement/consensus on what the future “new normal” for the size of the Fed’s balance sheet will, or should, be – or what the appropriate long-term neutral interest rate is likely to be.

There is also the fact that there could be big changes on the board of the Fed. US President Donald Trump has the potential of installing as many as five new members to the seven-seat board in coming months, including possibly replacing Ms Yellen whose fixed term comes up for renewal in February 2018. This could drastically change the Fed’s future monetary policy.

In simple terms it is likely Mr Trump’s new nominees to the Fed board will shift monetary policy from infrequent and small interest-rate hikes (in the hopes of triggering lower unemployment and more growth) to more aggressive rate hikes (in the hopes of hitting inflation targets).

A potential issue with such a change in policy was highlighted by the so-called “taper tantrum” of 2013. To recap, this was when US economist Ben Bernanke inadvertently sent yields surging and bond prices falling when he said that tapering would begin only if and when there was consistent evidence that US employment conditions were improving.

Mr Bernanke also specifically stated that, even after tapering started, the Fed would not allow US monetary conditions to tighten and would keep short-term interest rates near zero for a very long period – at least until 2015, and quite possibly beyond. Yet, despite this, markets were spooked by the potential change in direction.

Returning to the present day, on top of the recent announcements by the Fed, in a wider context the Bank of Canada raised interest rates for the first time in nearly seven years in July, while both the ECB and the Bank of Japan have hinted that their quantitative easing programmes could slow or even reverse, changing demand to supply.

The result of all this is that many investors fear heightened volatility, falling bond prices and even perhaps a bond market crash as central banks change course, but others take the view that people have been saying there is a bond bubble for years, but bonds have continued going up.

One of the main current arguments against a potential bond market crash is that global growth is still low, which means inflation is unlikely to become a problem for an extended period of time resulting in a slow, well communicated tightening from the US and others with any changes priced in by investors in advance.

There is no doubt that following Mr Bernanke's “taper tantrum”, central banks have to date been very careful in testing the waters by giving markets hints of their plans and taking tiny steps. However, as I have said, there is no guarantee this strategy will continue in the future, especially as the leadership at the Fed changes. 

Where to invest in the bond market

The bond market is a many-headed beast with government bonds and company bonds, short-dated bonds and long-dated bonds, index-linked bonds and western and emerging market bonds, to name just a few. So where should you be investing?

It depends on your outlook for the bond market, bearing in mind the risks outlined. I talk to many fund managers and some are simply not investing in the bond market at all, preferring instead to hold cash or dip their toes in the absolute return space. Others are still confident in various pockets of the market, such as high-yield bonds, but are aware of the duration issue in terms of future potential increases in interest rates.

A common theme for many multi-asset managers is to allow their bond exposure to perhaps be managed by fund managers who are able to quickly adjust their portfolios depending on the unravelling of events and, therefore, strategic bond funds where the manager has flexibility to invest as they see fit across the range of fixed interest opportunities available are currently popular.

Quantitative easing has been the biggest thing to happen in markets for decades. Its reduction is also going to be the largest thing to happen in decades. No one can say for certain how markets will react to its withdrawal and unwinding.  

The fact is that central banks are, in effect, walking a tightrope with no safety net and the question investors might ask themselves is whether certain bonds have changed from being risk-free return to return-free risk and act accordingly.

Andy Gadd is head of research of Lighthouse Group