Jim Cielinski, Global Head of Fixed Income, explores the global pick-up in yields but suggests that growing divergence in economies and monetary policy may herald a less uniform fixed income market.
Has the first half of 2018 developed as expected?
The long-anticipated upside breakout in interest rates has arrived. Reacting to expectations of central bank policy normalisation and synchronised global growth, yields pushed higher across both developed and emerging markets. Shorter-dated US-dollar yields led the charge higher, driven by expectations of tighter policy. The US Federal Reserve learned that if you call for something long enough, it just might happen, as inflation finally approached their 2% target. Although inflation also crept higher outside of the US, price pressures remain remarkably muted.
The inflection point in rates and policy expectations allowed for the re-emergence of market volatility, which may be among the more important developments of 2018. Policy uncertainty is high and likely to remain so.
Bond markets provided a noteworthy reminder in recent quarters that a tough period for bonds does not equate to a catastrophe. Yes, yields are rising, but total returns were still only modestly negative.
Is a tighter policy regime now priced in by fixed income markets?
Bond bears face a much harder task from here. The revised expectations for monetary policy are now reflected in markets. Real yields have moved up from their depressed levels, and some short-term inflationary pressures have been rekindled. Pushing yields materially higher from today’s levels will require a shift in longer-dated inflation expectations. Short-term cyclical forces will win the battle, but long-term secular deflationary forces still have the upper hand in the war. Economic growth, albeit positive, already appears to be moderating and turning less uniform. This is likely to provide a cap on interest rates in the near term and stem the dollar weakness witnessed over much of Q1. As yield levels pierced 3% for 10-year US Treasuries, other global markets have grown increasingly more expensive on a relative basis, a dichotomy which should subside.
Are you finding renewed opportunities within fixed income?
Higher yields create a more compelling case for bonds in a diversified portfolio. More attractive starting valuations allow for better prospective returns and a strong alternative to expensive, riskier assets. With elevated uncertainty, expect oscillation between comfort with robust growth policy and fear of a policy mistake. Global economies have reached peak convergence and we expect the reversal of this to create many opportunities within country selection strategies, and should prove a boon to emerging markets. Shorter maturities, on a risk-adjusted basis, now appear more compelling than at any time in the last three years. Bond markets may not yet be cheap, but opportunities to produce returns abound.