Monetary policy divergence set to create opportunities for bond investors – BlackRock
Take a flexible and unconstrained approach to asset allocation in 2014, say Rick Rieder and Scott Thiel, co-managers of the BGF Fixed Income Global Opportunities Fund.
• A period of monetary policy divergence is set to create new opportunities for bond investors
• Continuing debates over the US ‘fiscal cliff’ will remain a source of market volatility, but the US Treasuries’ yield curve and bond yields should continue to drift higher
• We are positive on Portugal, Slovenia and Ireland due to valuations relative to fundamentals and their improving financial positions. We also favour India in emerging market debt
For the first time in many years, financial markets are approaching a period of monetary policy divergence. The world’s four major central banks – the effective determiners of pricing across the global bond market – are set to find themselves taking considerably different stances on monetary policy. We believe that this offers investors a number of new opportunities.
The US Federal Reserve (Fed), the world’s most influential central bank, is about to begin a monetary tightening cycle. It may be next month or next quarter, but the Fed will taper its asset purchases and it would be reasonable to assume that policy tightening will inevitably follow.
In contrast and, fittingly, on the other side of the world, the Bank of Japan has just begun its own unprecedented and very significant quantitative easing (QE) programme in an attempt to wake the slumbering giant that is
the Japanese economy.
The approach of the European monetary authorities is somewhere between the two. The European Central Bank (ECB) has maintained its very dovish stance, and its focus on ending interest rate fragmentation across the continent. If successful, this should ensure that companies trading on the periphery of the EU are offered similarly low financing rates to those enjoyed by their German and French peers.
Under Mark Carney, the Bank of England has introduced forward guidance to keep short rates low and relied on the weakness of economic data releases to guide longer-term interest rates for the world’s sixth largest economy. We believe that this may prove very tricky as the UK economy begins to accelerate. In addition, relying too heavily on forward guidance, effectively attempting to ease without actually easing, may ultimately detract from the Bank’s long-term credibility.
In summary, the world’s most influential central banks are fundamentally doing different things, because they are driven by diverging economic cycles and policy objectives. The technical situation of global bond markets is also
important to bear in mind, with the Fed, Bank of England and Bank of Japan not only setting their short-rate policies but also buying significant amounts of their own long-term government debt. Therefore, any changes in their approaches are bound to have dramatic consequences both on local bond markets and the level of global capital market liquidity.
The September Fed Policy Decision
In September many market participants, including our team, were widely anticipating some degree of QE tapering, which arguably was well-priced into market expectations. While we had a somewhat different view from the rest of the market early on that the Fed would not taper their support of the mortgage market, we find it surprising that the US monetary authorities chose not to use this window of opportunity to act. In our view, the decision to postpone this move will broadly be supportive of government bond markets, as well as risk assets until discussion of the timing for the taper recurs. From an investment perspective, we think that the lack of tapering (and the absence of guidance on when it may occur in the future) should bring down our expected range for 10-year yields in the next couple of months.
We believe that the Fed was citing three reasons for not going ahead with tapering in September. They were the absence of tangible positive momentum in the employment market, housing market stagnation after a rise in mortgage
rates and, finally, fiscal issues. If, and when, the Fed proceeds with tapering, we expect the long-end of Treasuries’ yield curve to head moderately higher, led by an expansion of real rates.
We are positive on government bonds issued by three of the eurozone’s ‘peripheral’ countries – Portugal, Slovenia and Ireland, given that all three have valuations that look compelling relative to their fundamentals. For example, Portugal’s economy has been doing surprisingly well due to export growth, with the banking sector stabilising and the deficit expected to close in 2015. Meanwhile, in Slovenia, while we expect bank recapitalisation costs to exceed earlier estimates due to economic deterioration, the government should be able to cover them without any assistance through the IMF or the European Stability Mechanism (ESM). In addition, an expected government bond issue in the first quarter of 2014 should lead to further improvement in the country’s financial position.
We expect Ireland to successfully exit the Troika programme this year after consistently meeting its requirements with a primary surplus in 2014, which will put its debt on a downward trajectory. The Irish economy is also very sensitive to the rate of global growth and will stand to benefit from any global improvement in global economic indicators, particularly those emanating from the UK and the US.
Finally, we think that high yield corporate bonds look relatively attractive. Some investors highlight the fact that high yield bond issuance has been very significant but it is worth remembering that much recent issuance was designed to push the maturity spectrum longer. In our view, high yield debt will continue to do well, assisted further by any rises in equity markets, although we should not expect spread compression to be as significant as it has been in the past.
In summary, we expect to see many new investment opportunities in the global bond market as we come to the end of 2013 and look to 2014. The divergence of major central banks’ monetary policies brings with it changes to the risk and return landscape for global bond investors, so we believe having a flexible and unconstrained approach to asset allocation will be increasingly important.