Commentary: Searching for peak yields as we enter a dangerous new phase
The significant tightening in financial conditions resulting from the increase in real yields poses new risks for the global economy. At current yields, fixed income is well placed to weather a sudden downturn in the market cycle.
The combination of strong growth and low inflation feels like it’s too good to be true, but that’s been the theme over the last few months. Markets are currently pricing higher long-dated yields linked to data, suggesting surprisingly strong growth from the US economy – a far cry from elevated recession fears earlier this year. The US deficit is the new concern and the enormous amount of fiscal spending has been driving a further rise in long-dated (10 and 30-year) bond yields to levels last seen before the GFC. This has tightened financial conditions significantly and now poses new risks for the US economy.
Even though the US Federal Reserve (the Fed) has tightened monetary policy at the fastest pace in 40 years, it is still confronted with sticky labour and inflation data. These have been obstacles to signalling a definitive end to the tightening cycle or when the Fed will begin to ease policy. At the same time, the fiscal deficit has expanded to levels rarely seen with full employment. These constraints are exactly why the Fed has indicated a ‘higher for longer’ stance. While we do think yields might be close to peaking, solid growth data as well as the Fed’s focus on growth could keep yields at current levels, unless a clear catalyst emerges.
The Euro area is exhibiting a lower sensitivity and correlation to the US market and in contrast to the US bond market, it failed to post a new high in yields. We are seeing more evidence of the macro decoupling with downside surprises in both growth and inflation across Europe vs upside surprises in the US. Both manufacturing and services sectors of the European economies are in contraction territory with the risk now that the European Central Bank may have overtightened. The ECB could be the first major central bank to cut interest rates in 2024, with more evidence that further monetary tightening is no longer necessary.
In Australia, recent data has beaten RBA forecasts, and we expect a hike at the November meeting to 4.35% in response. Also important to this shift has been more explicit commentary from the new RBA governor, Michele Bullock around the RBA’s data dependence with a low tolerance for slower-than-forecast inflation decline and a willingness to hike if there is a material upward inflation revision. The RBA’s hiking cycle has been characterised by a greater emphasis on policy rate smoothing relative to other central banks. A hike next week would still be consistent with this cautious reaction function – with the policy rate only modestly restrictive and real rates negative. A key risk is whether the more robust backdrop (reaccelerating domestic inflation, labour market resilience, resurging domestic house prices, global rates higher for longer) causes the RBA to reassess this view and move the cash rate higher towards comparable central banks.
Eyes on Japan
Japan is now getting interesting from a rates perspective as the Bank of Japan continues to make adjustments to their yield curve control framework to allow more flexibility, as inflation forecasts are upgraded for 2024. Continued upward pressure in Japanese bond yields also has implications for global bond yields, especially in the US.
Amidst the volatility, our overall view at present on the cycle is that it remains very favourable for fixed income. The downtrend in global growth remains in place as long and variable lags of policy tightening work their way through economies. High quality fixed income securities above 5% are now displaying the best absolute and relative value since 2012, attractive vs both cash and equities. Elevated yields also provide a very good base for returns in a soft or hard landing scenario.
Looking out beyond the cycle, the ‘next’ economy is one where inflation is likely to be structurally higher, driving greater macroeconomic volatility. This outlook has a number of implications for portfolio structure and active management. Firstly, the role of fixed income is shifting, where yields will be structurally higher on average, providing higher levels of income generation to portfolios. Secondly, we want to seek inflation protection, via instrument or issuer and lastly, strategically limit exposure to macro-economic volatility, but tactically manage exposure. Overall, this favours inflation-protected credit assets, inflation-linked bonds vs nominals, and shorter tenors through the economic cycle to deliver dependable income.
We are cautious in positioning for the end of the tightening cycle as short term interest rates are likely to stay higher for longer, so rate cuts may take some time to be priced into markets. Our portfolio holds modestly long interest rate positions, constructive positions in higher quality corporate debt and government spread sectors, and limited exposure to riskier debt.
Within these broad settings there is considerable dispersion between countries and sectors that are providing opportunities. In particular:
- We prefer interest rate duration in Europe, where we are seeing confirmation of a peak in the interest rate cycle. In Australia, our preference is to be holding mid-curve high quality spread product to generate a high level of income for the portfolio.
- In the US, the yield curve has steepened from very inverted levels earlier in the year, driven by the rise in longer-dated yields. We continue to position strategically for steeper yield curves that will ultimately perform when we approach the turn of the policy cycle, as the market prices in lower cash rates.
- We also continue to like inflation exposure in the US as markets seem optimistic about a return of inflation back to low levels.
- Our strongest conviction is in Australian investment grade corporates. Spreads are wide relative to the high quality/low risk of the underlying issuers. We also like Australian Tier 2 bank sub-debt, in which issuance to meet regulatory capital requirements is keeping spreads wide, relative to the low underlying risk.
- Globally our credit exposures are limited. In October we lifted some credit protection across high yield markets to further add to carry within the portfolio, positioning for a higher for longer environment.
- Across higher quality spread product, we favour the sub-sovereign (state government and supranational) issuers over government bonds.
As uncertainty persists in the global economy, high quality fixed income offers attractive income levels to asset allocators as we wait patiently for the end of the cycle, when once again fixed income is likely to provide good cyclical diversification.
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