Cash & Investment Management

Global Bond Comment – Q3 2016

Tuesday 27th September 2016

It has been yet another fascinating period for the global bond market as QE and an interest rate cut occurred in the UK. At the same time, bond investors were factoring in a US interest rate rise, as the labour market and the wider economy continued to improve. Volatility in the gilt market (based off 10-year gilt futures) has soared to close to the highest levels seen this century, on a par with the Eurozone debt crisis of 2011/12 and behind only the global financial crisis of 2008/09. In fact, investors have termed this situation the ‘new normal’, with slow growth, low yields and high volatility. The natural interest rate has been fundamentally reduced and in the US, the Federal Reserve may only have to tighten by 0.50% more to reach the target.

The ease in the UK’s monetary policy came in the wake of the Brexit vote and the UK bank rate of 0.25% could well be reduced further by the end of the year to only 0.05%. The Governor has already made it clear that he does not like negative interest rates. QE has also caused a significant flattening of the gilt curve relative to other markets. The ten year yield is currently standing at 0.70%, having started the quarter at 0.90%. The £10 billion corporate bond buying scheme has ultimately led to the highest issuance in the sector since August 2009. August saw a staggering £8.6 billion of investment grade issuance.

Given the challenges facing the UK, the OECD has recently suggested a more active use of fiscal policy. This would see a high level of public spending which would smooth any short term negative shortfalls. The Chancellor is likely to scrap the previous target of reaching a fiscal surplus by 2019/20 in the next Budget. Projects should focus on infrastructure areas such as rail and road and there could well be further initiatives on the housing market.  Approximately £10 billion of projects would boost the overall GDP growth rate by 0.5%. The MPC are willing to maintain an accommodative stance despite some measures, such as an imminent 4% unemployment rate, indicating that tightening should occur.

The tightening phase that the US Federal Reserve has now entered makes the appeal of US Treasuries more difficult. The ten year yield is now standing at 1.60%, having started the quarter at 1.47%. The upcoming Presidential election has also added to investor anxiety levels.  Both candidates are also in favour of additional fiscal stimulus, with Trump’s proposals larger by a magnitude of 1% of GDP. However, economic growth for the rest of the decade looks steady at circa 2%, with no real issues for inflation either. The economic cycle is clearly in the very mature phase and certain indicators are flashing rising recessionary risk. This is likely to come from the corporate sector which is experiencing some retrenchment.

The Bank of Japan has held off moving ever deeper into negative rate territory but has interestingly made a pledge to maintain the ten year yield at 0%. To do this, a more flexible approach to bond purchases will have to be made and the Bank will be conscious not to flatten the shape of the yield curve. Remember, they want banks to lend. This policy framework will indeed see a further easing in interest rates, probably in November from -0.1% to -0.3%. There has also been an adjustment in the inflation targeting, which is now aimed to be on average 2% over the course of the business cycle.

Europe continues to be hampered by a poor structural backdrop, with significant slack in the labour market and poor longer term demographic factors. Germany for instance, pre 2008 averaged 1.8% per annum in productivity growth, this has now decelerated for the last five years and has actually fallen below zero. Despite the loose monetary policy and considerable ECB stimulus, there remains a lack of appetite for increased credit and so GDP growth will struggle. The consensus for 2017 is a slowdown to 1% growth. The ten year German bund yield remains at a negative -0.14%. The ECB is likely to extend the QE programme beyond March 2017 and may well take note of the afore-mentioned policy shift in Japan.

The average yield on investment grade sterling corporate bonds is now at a record low at just over 2%. Prices in the UK have been boosted further by the Bank of England decision to launch a purchase programme. It remains unclear if this is an effective transmission mechanism to boost growth or simply stoking further an asset bubble. In the wider high yield market, there is also a substantial level of overvaluation with investors too relaxed on recessionary risks, notably in the US.