With the US Fed, ECB and Bank of England looking to tighten monetary policy, T Rowe Price bond manager Quentin Fitzsimmons examines where to look for opportunities
With global growth on a firmer footing, several major central banks are moving toward tightening monetary policies. The potential impact of such a synchronised move by central banks remains relatively unknown for bond markets and raises the question of whether there is currently any value in holding fixed income.
After years of ultra-accommodative monetary policies, the tide seems to be turning. The Federal Reserve is unwinding its $4.5trn balance sheet from this month and looks on course to deliver its third rate hike of the year in December.
Among the other major central banks, the Bank of Canada has already raised rates twice since July and the Bank of England is inching closer toward hiking rates for the first time in a decade in order to cool inflation pressures. It is also likely the ECB will soon confirm a tapering of its bond-buying program, expected to begin next year.
Expect bond volatility on global tightening
A synchronised tightening move among major central banks could give developed government bond markets a volatile ride. Navigating this uncertain environment will require a smart approach, with specific positioning on the yield curve likely to take centre stage within portfolio construction.
US long-dated bonds should remain well anchored, despite pressure increasing on the short-end of the curve. Indeed, while the Fed clarified its rate hike cycle for the next 12 months at its latest monetary policy meeting, it also lowered its projections for the terminal rate – the rate at which the economy neither expands nor contracts – to 2.75 per cent from 3 per cent.
The opposite may be true for Japan, where there is speculation the Bank of Japan may reduce its buying of longer-maturity bonds, which could result in a steeper curve. In other bond markets, technical factors such as demand from domestic investors will also matter. While the short and belly of the UK curve look vulnerable in the current environment, potential support exists from technical factors for 50-year gilts – such as possible demand for this part of the curve from UK pension and insurance companies needing to meet future liabilities.
Look further afield for less rate sensitivity
In addition to yield curve positioning, another way of navigating the current environment is to identify countries that are potentially less sensitive to a rising rate environment. Australia stands out in this regard. Although its domestic bond market is likely to react to a selloff in US treasuries, it should quickly revert to being driven by domestic fundamentals once the market settles.
Israel also offers a potential refuge from interest rate volatility. With little sign of inflation in the country’s economy, the Bank of Israel is likely to remain on hold for the foreseeable future. However, the yield curve seems to be pricing an interest rate path similar to the one likely to be followed by the US. As a result, the implied steepness of the curve makes it a compelling opportunity in the current climate.
Another market that has the potential to be less correlated with the major bond markets is Malaysia. The strong domestic investor base in Malaysia should help to put a cap on rising yields, while the interest rate volatility is generally lower for Malaysian government bonds.
Should investors ignore low-yielding economies?
However, should low-interest countries be dismissed? There are merits of investing in low-yielding markets where financing is cheap, which can offer attractive relative value on a currency-hedged basis – despite accommodative monetary policy by the local central bank.
Sweden is a perfect example of a country where we continue to find value despite bonds trading at expensive levels. The positive currency-hedging effect makes it attractive for dollar, sterling and euro-based investors.
In all, the environment is shifting away from outright duration views toward relative country positioning and yield curve positioning as central banks try to navigate the tricky path of prudent monetary tightening. Looking for hideout places in fixed income feels very much like an active position at present.
Quentin Fitzsimmons is portfolio manager of the T Rowe Price Dynamic Global Bond fund