Fixed IncomeMar 1 2017

Bonds: volatility offers opportunities

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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.

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.

The distortionary impact of QE on government bond yields worldwide has been enormous. Ongoing QE in Europe, Japan and UK serves to perpetuate this. Central bank balance sheets around the world have swollen exponentially since the global financial crisis and some argue that these bloated sheets should begin to contract as and when economic conditions dictate. This is in effect the purist interpretation of how QE should work once it is deemed to have been successful. The impact on bond markets would be dramatic as vast tranches of existing government bonds returned to the open market. Potentially this could be a major component of a perfect storm that forces bond yields to rise back to more attractive levels.  

On many occasions over the past few years market commentators have prematurely forecast the end of the 25-year bull market in bonds. This headline grabbing prophecy has proven to be more elusive than many seasoned observers expected. Without wishing to portray just one side of the story, there was a telling example of just how dangerous too much duration can be when bond yields rose sharply after hitting historic lows in August. Benchmark long-dated gilts fell by some 40 points (20 per cent) in a virtually straight line, displaying the kind of volatility normally reserved for certain other asset classes.  

Holders of bonds have enjoyed strong total returns at times as a result of the duration effect that has benefited capital values when yields have fallen. This phenomenon is unlikely to occur in any meaningful sense in 2017, as yields remain historically extremely low. Therefore, investors would be unwise to expect a total return of much in excess of prevailing market interest rates during the year ahead. There is also a strong possibility that there will be periods of volatility that could prove to be unsettling for holders who are not fully aware of the incumbent risks.

The global outlook is extremely complex. With the forthcoming European elections and the results of the US presidential election, the political background has become very uncertain. With plenty of scope for future political shocks during the coming year, particularly in Europe, bond market investors will be wary of complacency. The rest of 2017 promises to be full of surprises and opportunities. From an asset allocation perspective there are numerous reasons why portfolios should be as well diversified as possible, because if 2016 has taught us two things it is that anything can happen and probably will, and that even if you knew the outcome of key events, your reaction may well not be the correct one. 

Ian Entwisle is head of fixed interest of Rowan Dartington

 

Key points

In the UK the 10-year gilt yield started 2016 at about 2 per cent and subsequently rallied.

Monetary policy cannot be eased much further.

 2017 promises to be another year of surprises and opportunities.