Cash & Investment Management

Fixed Interest Review Q2 2017 – Yields well supported and expensive..

Wednesday 21st June 2017

It has been a largely positive quarter for fixed income investors, although the magnitude of the moves has been relatively small. In the UK, Gilts have largely outperformed as investors have taken a cautious view on the economy and the ten-year Gilt yield has moved down from 1.13% at the end of the first quarter to hover around 1% as we finish this quarter. Despite some mixed messages from the MPC, it would appear that interest rates are going nowhere in a hurry. The short-term inflationary pressures have been balanced by a lack of upward wage pressure and a fall in consumer sentiment.

The Bank of England governor, Mark Carney, is clearly still worried by the impact of Brexit on the economy. This despite the fact that the recent weakening in Prime Minister’s May position, means that the UK is more likely to go down the ‘soft’ exit route rather than the potentially more disruptive ‘hard’ route. At a recent MPC meeting, investors were surprised by three members unexpectedly voting to raise interest rates, citing the full employment situation. Inflation stands at 2.9%, well above the government’s 2% target and higher than the Bank anticipated in its May inflation report. What the Bank would really like would be a situation where the threat of higher rates leads to a firmer currency, lower import prices and weaker inflation.

In the US, the Federal Reserve is desperately trying to get to a position where it can act positively from, in the wake of a future downturn in the US economy. They are looking through any near term decline in inflation rate and focussed on the full employment situation. It feels as though the ‘neutral’ interest rate has declined in recent years and there may only be two or three more rises until they feel the job is done. The balance sheet contraction is harder to predict, but will probably be around $1 trillion by 2020. Markets would be well advised to pay closer attention to the forward guidance. This is an evolving Federal Reserve that, absent a major economic downturn, will maintain a more hawkish tilt to monetary policy.

Despite the actions described above the ten-year US Treasury yield has moved down from 2.38% at the end of the first quarter to just over 2.1% as we close the second quarter. Interestingly recent data has shown that China’s holdings in Treasuries are at a six month high as the belief of a stable currency emerge. 

The ECB’s forecasts for inflation across the region have been reduced to only 1.5% in each of the next three years. The main reason cited is the weakness in energy prices in recent months. Forecasts for core inflation, excluding energy and food, are little changed. Despite interest rates remaining unchanged, the stance is slowly changing. Firstly, the meeting statement no longer refers to the possibility that interest rates could be lowered further. Instead, the ECB said that it expects rates to remain at present levels for an extended period of time. The tapering of asset purchases is also pushed back, possibly until 2019. Some commentators have argued that a wider range of assets could also be used if external shocks came along, such as equities.

In France, French President Emmanuel Macron is celebrating a convincing victory in National Assembly elections that gives him the mandate to push through wide-ranging social and economic reforms. The priority for the government in the coming weeks will be labour market reform. From a fiscal perspective, the President is aiming to reduce the public deficit below 3% of GDP in the current year. Interestingly, Macron has suggested that the Eurozone should have both a region wide finance minister along with a budget. Angela Merkel has suggested this could happen if the ‘circumstances were right’ but fundamentally Germany do not want to simply prop up the indebted nations of the region.

In a recent survey, a staggering 84% of investors believe that corporate bonds are overvalued; this is the highest ever reading and frankly sums up the position we face. Of course, by historical standards, many asset classes appear to be expensive and there will be a lower ceiling in interest rates as well. Despite the relatively low levels of volatility, there are early signs that investors are becoming more nervous on the high yield sector. As highlighted in last quarter’s comments, the energy sector is an important component. The current weakness in the crude oil price is a clear negative and the implied default rates are likely to increase as 2017 progresses.

Investors have also been chasing Emerging Markets bonds with lower graded territories such as Ecuador, Sri Lanka and Turkey raising a greater proportion of funds. Much still depends on fund flows and the movement of the US $.