Cash & Investment Management

Fixed Interest Review Q1 2017 – Yields contained

Friday 31st March 2017

Fundamentally it has been a dull quarter in the fixed income markets. After the sharp rise in yields in the last two quarters of 2016, there has actually been a decline in some of the headline yields thus far in 2017. This would be a surprise, particularly in the US, where interest rate rise expectations have actually increased in the current calendar year. As the period has progressed, investors have positioned slightly more cautiously. This steady state may well stay in place until the Federal Reserve increase interest rates again. The consensus is for September but a June move is a possibility which would be a shock.

One of the containing factors could be growing signs that the Trump reflation trade is faltering. The recent defeat of the Healthcare bill, which was after all Trump’s first major legislative push, has forced investors to rethink. Divisions between conservative and centrist Republicans are clear to see and going forwards look set to hamper the administration’s other policy efforts. Notably, the pushing back of tax reform could also significantly dampen investor confidence in reflation trades in the near-term. The long term finances of the US could also come under increasing pressure. If all the current policy initiatives were to happen, then the forecasts suggest that federal debt will hit 98% of GDP by 2024, that is $24 trillion!

The current US ten-year Treasury yield stands at 2.38%, having finished 2016 at 2.44%. Forecasts for the coming year are disparate with the consensus estimate being an increase in the yield to 2.90%, with some forecasts as high as 3.50% and as low as 2.00%. We have eluded elsewhere that we are sceptical of some of the growth forecasts with many structural growth constraints and we believe yields will continue to be supported.

Certainly from an inflation perspective, it remains relatively well contained despite a 4.7% unemployment rate, the recent fall in energy prices has helped, although food prices are creeping up. Despite the positive readings on inflation, it’s unlikely that Fed officials are going to project a substantial overshoot beyond their 2% goal. That’s partly because inflation is slow moving, and the Fed revises its forecasts only incrementally.

In the UK, the ten-year Gilt yield stands at 1.17%, having finished 2016 at 1.24%. There are signs that recently the MPC has become more hawkish, largely in response to the firm economy and rising inflation expectations. Indeed, at the March meeting, one of the members voted for an immediate interest rate hike. However, with much of the increase in inflation due to temporary factors and some nerves surrounding Brexit, the markets will probably only price in an interest rate increase in 2018. However, it is possible to foresee a scenario where inflation takes hold and interest rates are forced to rise sharply. In this case, the effectiveness of gilts as a diversifier would reduce.

There clearly is a risk that in pursuing a ‘hard’ Brexit that economic growth and confidence is so shaken that the Bank of England will need to undertake even more Quantitative Easing. This would involve more corporate bond buying rather than Gilts. Maybe this scenario is more relevant than we think and explains why Gilts, on the face of it, look so expensive relative to US Treasuries with the same maturity. 

In Europe, the political situation has been a dominating factor but despite this, the core economies have been displaying impressive GDP growth. Business surveys have been highlighting a pick-up in activity across all areas, although this has been particularly impressive in manufacturing. It is important to remember the make-up of the Government market. From a European perspective, France and Italy make up approximately half of the entire European government bond universe, while Germany only makes up 18%. There is also a significant amount of debt to mature in the 5-10-year period.

The ECB will slow the bond purchases this month to €60 billion a month and some investors are deliberately searching for value in bonds that are not eligible for the programme. The majority of investors are not considering that Le Pen has a chance in the French elections. Let us hope this complacency is not misplaced. The result of a Le Pen victory would hit certain sectors particularly hard, especially those that would lose in a demonetisation of the Euro. These would include the banks and insurance companies, with banks facing a run on the deposit base.

In the higher yield/junk market, spreads have risen in recent weeks as investor risk appetite has diminished. In the context of last year however, the high yield spreads are still narrower, largely due to the recovery in the energy sector. Emerging Markets spreads are also relatively tight not far above record lows seen last decade.