Fixed Income  

Bonds: volatility offers opportunities

Bonds: volatility offers opportunities

The year 2016 was extraordinary for bond markets and investors generally. The Brexit vote, a reduction in UK policy rates that no-one foresaw at the start of the year, rising inflation as a result of the commodity and oil price rally, and the election of Donald Trump as US president were among the many factors that added up to a tumultuous 12 months.

In the UK the 10-year gilt yield started 2016 at about 2 per cent and subsequently rallied as various factors caused investors to perceive that the bond bull market was not over. This rally was further supported by the unexpected outcome of the Brexit vote, which propelled bond yields to extraordinarily low levels.

Some commentators have said that the interest rates seen at this inflection point were as low as they have been for 5,000 years (although how this comparison is derived may be open to debate). Ten-year gilt yields touched 0.50 per cent in August as investors foresaw an environment where interest rates were set to remain at levels even the most pessimistic of forecasters had not earlier contemplated.

Article continues after advert

With deflation having been a major concern for central banks, recent inflation data globally has pointed to an uptick in consumer prices. The bulk of this can be explained by the rally in oil and commodity prices from their very depressed levels at the end of 2015 and the beginning of 2016. The UK also has the added catalyst of a much weaker sterling since the Brexit vote.

However, the Bank of England has made it clear that it will look through the inflation figures and the long-term background for prices remains that the deflationary forces that have prevailed for so long will continue to keep inflation subdued. One key determinant of how the UK bond market performs in 2017 will be news surrounding Brexit negotiations. Should the pound weaken further, this will have a negative impact on the inflation outlook, which should translate into higher yields. However, if the negotiations are deemed to be going well and the pound rallies then this will have the opposite impact.

Monetary policy cannot be eased much further. With negative policy rates in Japan and the Eurozone, and UK base rates at 0.25 per cent, other tools are going to have to be employed as and when authorities seek to support their respective economies. The only major developed economy where rate rises are firmly on the agenda is the US as the Federal Reserve responds to the relative strength of the domestic economy. Like all central banks, having the ability to reduce rates as a policy response is a fundamental tool and the Fed is keen to have this capacity should the need arise.

Quantitative easing remains a preferred tool of central banks, but there is now a strong suggestion that this alone is not sufficient to ensure the long-term economic improvement the authorities crave. Many commentators now feel that infrastructure spending along with other forms of fiscal stimulus are also part of the package that needs to be delivered to the global economy. The net result of this is likely to be increased government borrowing, which inevitably means more bonds being issued.