Bond markets have been in a sweet spot in recent years. Economic growth has been positive, inflation has been relatively benign, volatility and default rates have been low, central bank policy has been accommodative and the demand for income has been high. One of the biggest challenges we as fixed interest investors now face is what happens when one of the central pillars of this supportive environment — the still huge amount of central bank stimulus — is reduced.
The macro view — Stuart Edwards
When thinking about the bond market implications of central bank tightening, it is worth taking a step back to understand why central banks now want to withdraw liquidity.
Since the global financial crisis, global economic growth has been relatively low but synchronised across developed markets. Recently, this has been helped by a pickup in global trade as a result of a resurgence in Asian trade flows and a recovery in North American imports. Meanwhile, labour markets have continued to tighten, but thus far the historically low unemployment rate has not fed through to wage growth, which remains muted. This does not, in my view, mean that the Phillips curve (the inverse relationship between unemployment and inflation) is dead — it has just flattened. For structural (as well as short-term) reasons, I believe labour markets need to tighten further before we see a pickup in wages.
I am starting to see some signs that this is happening, albeit slowly. Although it is not my central view, I think the risk is that inflation turns out to be stronger (not weaker) than expected. Against this backdrop, central banks are seeking to normalise monetary policy.
I expect (and markets are currently pricing in) the Bank of England to stop at 0.50% or possibly 0.75%, and both the European Central Bank (ECB) and the US Federal Reserve (Fed) to taper quantitative easing over a long period at a slow pace. If that view holds, then fixed income markets should remain well-supported. However, there remain risks.
The ECB now owns nearly a quarter of the eurozone’s outstanding debt, and the tapering of asset purchases comes at the same time that the US deficit is predicted to increase to over US$1 trillion. This means that private investors will need to absorb a lot more supply in the US and Europe. It is difficult to see strong demand for government bonds at current yield levels, and so one would expect to see higher yields as the process unfolds.
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