The chances of economies achieving a “soft landing” as interest rates rise are “almost zero”, but bond investors can profit either way, according to a several fixed income investors.
Central Bankers are presently trying to raise interest rates sufficiently to force inflation down. But in doing so they want to avoid a sharp recession, and ideally achieve a so-called soft landing.
Phil Milburn, bond manager at Liontrust believes the fact that core services sector inflation remains high, and global economic growth is weakening despite the full impact of tighter monetary policy not likely to be felt for several months due to the traditional lag between rising rates and real economy impact, means that a recession will occur later this year.
He said: “Bond market volatility is very high now, we are in a tug of war as policy makers battle to control inflation, but also have to ensure financial stability with the banking system.
"I don’t think we are headed for another banking crisis, but what is interesting is that the market has started to revise down its expectations of future rate rises in the US, the expectation had been that rates would rise by another 0.75 per cent, but this has been revised down to another 0.25 per cent.
"This is because the stresses in the banking system will cause banks to tighten their credit conditions anyway, which has much the same impact as higher rates, and is negative for growth."
If bank lending conditions are tightened at a faster pace than central bank interest rate rises, the money supply could contract at a greater rate than if rates rose, the velocity of the money supply, that is. As a result the pace at which the money that is created is moving through the economy is also slowed.
Both of those considerations are extremely negative for economic growth.
A situation whereby economic growth prospects are declining and market expectations are for rate rises to slow would intuitively be a positive for long duration bonds, but Milburn said markets were already pricing in this outcome.
With that in mind he has been reducing his duration a little by taking some profits, though he remains long duration overall.
'Not cautious to the maximum degree'
Paul Skinner, investment director at Wellington Management, said: “Markets had started to price in the soft landing. But what has happened is really just a classic interest rate tightening cycle as we have seen before.
"And we have seen that in the past bringing about a soft landing is not really something central banks have actually been able to do.”
He described the weakness in bond markets over the past year as “investors searching for weaknesses” as liquidity drained from the system.
He said the effect of banks being more cautious in their lending practices “does quite a lot of the central bankers' work for them.”
But he believes as economies deteriorate, central banks will be forced to loosen monetary policy, and for this reason, while he is presently cautious with his asset allocation, "we are not cautious to the maximum degree".
And one of the areas on which he is positive is bonds, as he feels that current yields are sufficiently high to allow investors to just collect the income. And if economic conditions deteriorate, the likelihood is that investors would choose to buy bonds for safety, which would mean profits from a rise in prices.
He said the biggest change in markets over the past year was that "where at one time markets seemed to reward investors for owning illiquid assets, whether that be unquoted equities or bonds, now liquidity is very much prioritised.
"It was also a world where volatility of an asset didn’t really matter as everything was low volatility, and that has changed. I also think we are approaching a period where the gap in economic performance between the US and Europe will narrow."
In terms of what that means for asset allocation, he said: "The likelihood is that the traditionally inverse correlation between bond and equity performance has been restored, which is extremely positive for bonds.
"Our view is that a pivot in central bank policy in the US is coming so we are long duration there, but in Europe are a bit shorter in our duration."
David.Thorpe@ft.com
