The important factors at play in today’s bond markets

Chris Manuell, Portfolio Manager and Director
Jamieson Coote Bonds

What are the most important factors at play in today’s bond markets? What’s the impact on capital markets?

The most important factor driving bond markets is the direction of global Central Bank short-term interest rates, as many of them are attempting to normalise rates in a post GFC era.  The challenge is to achieve this without roiling capital markets, as we are late in the global business cycle, and whilst countries are burdened with extremely onerous debt levels. The US Federal Reserve (the Fed) is leading the charge and appears intent on remaining on auto-pilot with a gradual tightening of the Fed funds rate from its current level of 2% in its quest of achieving the “neutral” rate – which is currently around 3%. Investors have to be gently reminded that longer bond yields are an approximate estimation of that neutral level, with US 10 year yields currently around the 3% level, JCB feels the risk of a material move through there will be slight.

Whilst we believe minimal impact will be felt from a tightening Fed with regards to the bond market, we are seriously concerned about other risk markets such as credit and equities as they absorb the rising cost of capital. Investors need to be reminded that currently around 50% of outstanding debt in the investment-grade universe is Triple B (BBB), even at the peak of the last credit bubble over 10 years ago, it was only 30%. The quantity of corporate leverage is also alarming; the corporate sector debt to GDP ratio is at near record highs at 45.4%, which is at a higher level than the previous recessions of 2001 and 2008.  This quality and quantity of leverage in the corporate bond market will come under the blowtorch of higher rates, pressuring default rates and widening credit spreads which historically leads to a recession.

JCB maintains that we are in a topping process for risk assets that will unfold over the following year, as financial conditions crimp corporate profits and the much vaunted synchronised global economic growth story continues to fade.

How will the trade war impact bond markets?

The ongoing global trade tensions should ultimately prove bullish for bond markets as they add to the concerns of a global growth story that is beginning to show signs of faltering – in particular the Euro area and Japan. The sugar hit of the US tax cuts should start to wear off and the increase in US interest rates should also impact the world’s largest economy.  The uncertainty provided by the trade war is already impacting business and investment, as capital expenditure is scaled back, and, the risks of global manufacturing moving lower from its cyclical highs will be heightened.

China has already acknowledged it’s concern about the ramifications of a trade war as it has recently embarked on an easing phase. Given Australia’s economy is heavily reliant on China, Australian high grade government bonds should perform well through any trade spat.

Overall bond markets thrive on uncertainty and a recent Bank of America Merrill Lynch Global Fund Manager Survey has respondents marking the trade war as the largest tail risk to markets since the 2012 European debt crisis. This bodes well for the bond market as an asset class during times of uncertainty, as there will be a flight-to-quality allocation into that market.

What is the significance of a flatter US treasury yield curve?

A flatter US yield curve historically occurs towards the end of the business cycle as the Fed tightens monetary policy in conjunction with economic expansion. A fall in the interest rate spread is generally achieved by a sharp increase in short term interest rates. Longer-term interest rates over this period will typically move in a more measured fashion which results in a compression of these rates.

The importance of the US yield curve is its predictive power of the future outlook for economic activity. Every recession in the last 60 years has occurred following an inverted yield curve, which is why the market is focused on watching a flatter curve evolve.

As an investor, what should I be concerned with about investing in today’s volatile bond markets?

Implied volatility across US Treasuries is currently close to all-time lows and the Australian bond market also continues to remain devoid of volatility.  With the RBA on hold, the 10 year bond has remained in a narrow 0.65% range since late 2016.  Similar periods of low volatility have coincided with major geopolitical or market moving events, the Lehman collapse, the flash crash of 2010 and Brexit.

Investors should be considering tail risk protection as the market begins to enter the final phase of the business cycle. That historically involves holding bonds in their portfolio.

What do rising US rates mean?  What’s the impact on my portfolio, how do I protect against rising US rates?

Perversely rising US rates are generally a signal that the economy is performing well. The timing and the magnitude of a rising rates environment is also crucial. A rise in rates corresponds to the cost of borrowing increasing and, as history tells us, it eventually becomes a negative influence on risk asset prices.  Through the course of history, there have been 13 Fed hiking cycles of which 10 have ended with a recession, which is why investors need to remain nimble and cognisant in a rising rate environment.

What about high yield – is it due for a correction?

JCB believes investors should remain cautious about high yield as it’s currently a ticking time bomb and can be likened to the mortgage market over a decade ago. Timing this is difficult, however our lead indicators are flashing amber – the inversion of the US 10 year / 2 year curve, global economic data is showing signs of a slowdown and the potential for an equity correction – these are all getting closer to completion.

The isolated examples of the imploding short-volatility ETF in February this year and the recent Facebook melt-down, which recorded the largest single day loss for any public company ever, are cautionary tales for a high yield market. Liquidity always provides support in a bull market and the thematics of a late cycle include the tightening of financial conditions and an evaporation of liquidity. Signs of liquidity diminishing this year have already started to surface in European corporate debt and emerging market government and corporate debt.  The herding nature of passive investment vehicles and the regulatory changes on banks diminishing their ability to provide liquidity in this current environment, makes for a very small fire escape when the tap of Central Bank liquidity is turned off.

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