By Morgane Delledonne
Almost a decade after the financial crisis, and after a prolonged period declining interest rates, many investors are still losing sleep about when and how the bull trend on the bonds market will reverse. They ask themselves how long the topsy-turvy world of negative-yielding bonds can last, and when “normal” interest rates will return.
With many Fed watchers expecting a rate rise sooner rather than later, nostalgic investors pine for a return to a traditional environment and a return to business as usual.
We believe that, however much investors yearn for a return to “normality,” we are not there yet. Many advanced economies are still experiencing anaemic growth, low interest rates and a high level of unemployment, namely the “new normal”, that requires a high level of monetary easing. And we’ve found that the quantitative easing programmes generally succeed at reviving the economy but only at a modest pace and with a considerable lag.
Additionally, cyclical and structural challenges have led long-term real interest rates to decline since the 1990s, mainly because of lower inflation expectations and lower expected return to capital investment. The resulting downward trend in productivity growth in advanced economies exerts pressure on central banks to keep long term nominal interest rates lower than in the previous cycles. In this context, we don’t expect an abrupt reversal of trend in the bonds market in the near term and we believe capital gains opportunities remain as long as central banks continue to expand their bonds purchase programmes.
This “new normal” paradigm requires lower benchmark rates than in the past. One of the most prominent examples of this is the decline of the estimated “natural interest rate” (i.e. the interest rate at which real GDP is growing at its trend rate and inflation is stable) in the US in the last decade. Historically, the tightening cycles of the Fed resulted in an average of 380 bps increase of the effective Fed Funds rate. Now, considering the shadow rate[1] the Fed has already increased its base rate by 337 bps since the end of the QE programme in November 2014, well before inflation started to pick up. As a result, the Fed would reach its natural interest rate level by only increasing the Fed Funds rate by 25 bps or 50 bps.
The massive stimuli from central banks have also distorted the fixed income market. By continuously pushing asset prices higher (and yields lower), the global economy and market have become increasingly reliant on these interventionist measures. As a result, any changes in market expectations on the future policy stance results in high levels of volatility – as investors fear a sudden stop of this bull trend. A series of market events such as the “Taper tantrum” in the US in mid-2013 and more recently the UK Gilt rally[2] and the Japanese government bonds (JGBs) sell-off are glaring examples of how sensitive the market is to changes in QE anticipation. This continued shift between “risk on/risk-off” periods has increased the overall volatility in fixed income.
The environment of “new normal” – slow growth, low yields and high volatility – favours duration risk, but limits the unsafe “search for yield”. With the exception of the United States, developed economies are likely to continue to provide monetary stimulus until growth and inflation actually rebound, offering opportunities for nominal capital gains in long-dated bonds. In the meantime, volatility should remain elevated as markets have become.
Morgane Delledonne is associate director – fixed income strategist at ETF Securities
[1] Black (1995) provided a way to calculate the value of the call option to hold cash at the zero lower bound. The shadow nominal yield is the observed nominal yields minus the value of the cash option.
[2] Investors repriced lower the Gilts yield curve after the BoE increased the gilt purchases target by £60bn, while investors sold-off long-dated JGBs is a response to rising doubts around the size and the duration of the Japanese QQE ahead of its upcoming review in September.
