Bond investors prepare for central bank change of course
Sign up for myFT Daily Digest to be the first to hear about undefined news.
Central banks around the world have spent the past 18 months buying debt at record rates, helping to support bond prices even as governments borrowed unprecedented amounts to fight the Covid pandemic. Now bond investors are wondering what happens when they stop.
The US Federal Reserve could “easily move forward” with plans to “cut” its $ 120 billion in monthly asset purchases from November, Fed Chairman Jerome said last week Powell. The Bank of England has gone further and said it will stop buying bonds when its current £ 150bn round of quantitative easing comes to an end at the end of the year. Even the European Central Bank, which faces more moderate inflationary pressures than its US and UK counterparts, has started to scale back its crisis buying program.
For Pimco founder Bill Gross, this trend reversal is worrying. Earlier in September, he called the bonds “garbage” – wondering how willing private investors will be to buy the supply of US Treasuries once the Fed pulls out.
With government bond prices falling sharply – and yields rising – likely to spill over into riskier debts, such as corporate bonds, the now retired “king of bonds” has suggested that the four-decade fixed income rally he has built his reputation on may be in reverse. Yields have “nowhere to go but up,” he said.
Many big players in today’s bond markets agree with Gross that bond yields, which hit record highs when the Covid crisis hit last year, are likely to rise as an economic rebound of the pandemic – along with a global spike in inflation – is leading central banks to cut back on their asset acquisition programs.
But there are few signs that they share his concern about a watershed moment in a rally dating back to the early 1980s.
“We expect yields to rise like our central case – probably the most in the UK, followed by the US and least in the Eurozone,” said Gareth Colesmith, head of global rates at Insight Investment. , an asset manager. “But we’re talking about a gradual response to gradual fiscal and monetary change – it’s not bond vigilantes pulling out their big clubs. This is not a dire prospect for fixed income by any stretch of the imagination.
Colesmith points out that the central bank’s huge buying programs over the past 18 months have reflected an expansion in government borrowing. As central banks curtail their efforts, fiscal authorities are expected to slow the pace of bond issuance. The relative pace of these two processes is what matters, he says – and the picture varies across economies.
FT Live Webinar
Prepare portfolios for recovery and growth.
Register to get your free ticket to join Thursday September 30 10:00 am – 11:00 am BST.
In the euro area, where quantitative easing is expected to remain a feature of the landscape for longer, governments may be more concerned with bringing budget deficits under control. Barclays analysts predict a net issuance of government bonds of 490 billion euros next year, up from 650 billion euros in 2021. Once the continued purchases of the ECB are taken into account, the new offer of Sovereign debt hitting the markets will be “close to zero,” they calculate.
In the United States, by contrast, the Treasury bill supply net of Fed purchases will remain firmly in positive territory in 2022 at more than $ 1.3 billion, according to forecasts by TD Securities.
Of course, the outlook for bond markets is not just a matter of crude arithmetic of government supply and central bank demand. Ultimately, the path for returns will depend on the outlook for growth and inflation, explains Simon Lue-Fong, Head of Bonds at Vontobel Asset Management.
As long as investors believe that the current explosion in inflation is likely to be transient, yields should not rise too much. Indeed, this summer’s global bond rally, which gathered pace just as investors began to speculate on the Fed’s “cut back” on asset purchases, offers a caveat to anyone assuming that central bankers are still in charge.
“The macroeconomic outlook trumps the history of tapering,” said Lue-Fong, who argues that the powerful forces that have driven inflation and interest rates down in recent decades remain in place. “Demographics, digitization – these are big trends that will keep rates low for the rest of my career,” he says.
However, even if this is not their main expectation, many investors are still worried about the havoc a sharp rise in government bond yields could wreak in riskier debt markets. So-called corporate bond spreads – the extra yield they offer over safe government debt – are near their lowest levels on record. This reduces the possibility for them to shrink further and soften the blow of rising public yields.
If yields and spreads were to rise together, the results of some corporate debt could be disastrous, said Andrew Jackson, head of international fixed income at Federated Hermes, the US investment manager.
“The spreads everywhere are pretty tight,” he says. “One of the great dangers is that the market has become complacent about the relationship between interest rates and credit spreads.”
In an environment of rising rates – which usually accompanies a strong economy – he suggests investors steer clear of the most indebted companies that might have trouble refinancing their loans. Instead, they should stick with those that still offer some spread but are positioned to benefit from a pickup in growth.
“If rates go up, there are definitely some places you can hide in fixed income,” Jackson said. “But you have to be careful.”