Market leaves Fed behind
Jenna Barnard, Co-Head of Global Bonds, believes recent market developments and weakening economic data support the view that the Fed is behind the curve.
4 minute watch
Key takeaways:
- The market environment is shifting with expectations that the US Federal Reserve (Fed) has been slow to act and may have to cut rates by 50 basis points at its September meeting.
- We have been saying for several months that lead economic indicators were weakening, particularly the more critical employment data, and that central banks needed to be cutting interest rates.
- The US 10-year Treasury yield is closely following the average path of the 1970s, suggestive of deeper declines in bond yields (and rises in bond prices) ahead if the historical path is maintained.
Behind the curve: An expression used to describe reacting to something after it has already happened.
Beta: A measure of a security’s volatility in relation to the wider market. If a security has a high beta then it is more volatile than the market. If it is low beta it is less volatile than the market.
Core fixed income: a term typically used to refer to investment grade government and corporate bonds.
Credit spread is the difference in yield between securities with similar maturity but different credit quality. Widening spreads generally indicate deteriorating creditworthiness of corporate borrowers, and narrowing indicate improving.
Cyclical: Companies or industries that are highly sensitive to changes in the economy, such that revenues generally are higher in periods of economic prosperity and expansion and are lower in periods of economic downturn and contraction.
Default: The failure of a debtor (such as a bond issuer) to pay interest or to return an original amount loaned when due.
Inflation: The rate at which prices of goods and services are rising in the economy. Core inflation typically excludes volatile items such as food and energy prices.
Investment-grade bond: A bond typically issued by governments or companies perceived to have a relatively low risk of defaulting on their payments, reflected in the higher rating given to them by credit ratings agencies.
Lead indicator: A piece or set of economic data that can help provide an early signal of where we are in an economic cycle.
Maturity: The maturity date of a bond is the date when the principal investment (and any final coupon) is paid to investors. Shorter-dated bonds generally mature within 5 years, medium-term bonds within 5 to 10 years, and longer-dated bonds after 10+ years.
Owners’ Equivalent Rent: The implicit rent that owner-occupiers would have to pay if they were renting their homes.
Recession: A significant decline in economic activity (negative economic growth) lasting longer than a few months.
Risk assets: Assets that have significant price volatility such as equities, commodities and lower rated corporate bonds.
Yield: The level of income on a security over a set period, typically expressed as a percentage rate. For equities, a common measure is the dividend yield, which divides recent dividend payments for each share by the share price. For a bond, at its most simple, this is calculated as the coupon payment divided by the current bond price.
Yield curve: A yield curve plots the yields (interest rate) of bonds with equal credit quality but differing maturity dates. Typically bonds with longer maturities have higher yields. A curve steepening is where the gap in yield between short and long-dated bonds grows.
US Treasury securities are direct debt obligations issued by the US Government. The investor is a creditor of the government. Treasury Bills and US Government Bonds are guaranteed by the full faith and credit of the US government, are generally considered to be free of credit risk and typically carry lower yields than other securities.
IMPORTANT INFORMATION
Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.
There is no guarantee that past trends will continue, or forecasts will be realised.
JHI
JHI
Jenna Barnard: It’s the beginning of August and we’ve seen some very dramatic moves in markets over the last week or so. Obviously, it’s been a very aggressive risk-off in risk assets and bond yields have collapsed driven by the US Treasury market.
In terms of what the team and myself are thinking, the direction of travel of these moves is not a huge surprise to us. Obviously, the speed and ferocity is remarkable.
But we actually did a webcast for clients at the end of June in which we talked about the end of “higher for longer” and the beginning of rate cuts across the developed world. How growth lead indicators had failed to rally in any meaningful way. How employment lead indicators were still very weak in the US and core inflation was coming down to the low twos in a number of developed economies.
So with that said, risk assets at that time were pretty much at sky high valuation levels. Credit spreads were close to historic tights. We saw very little value in credit other than at the very short end. And we thought that bond yields had huge potential to decline and the framing for us is very much focused on the historic precedent of how bonds behave after the last rate hike.
So this is a chart that we’ve been showing people all year.
Let me talk you through it. T + 0 on the X axis is where 10-year bond yields were at the date of the last rate hike. So any move up or down on the Y axis is the change in 10-year US Treasury yields in the months after the date of the last rate hike.
In all cases going back to the late 1960s, bond yields eventually do decline materially. Following the last rate hike, however, the paths diverge and as you can see, the most recent experience has tracked the 1970s. A very frustrating path.
But as we sit here today we see bond yields starting to fall materially below where they were at the date of the last rate hike, which was about 3.9% for US Treasuries last July. As I said, we continue to behave in a way that bonds have behaved in the past.
There is now the perception that the US Federal Reserve is behind the curve and they may have to cut by 50 basis points at their next meeting in September. We think that’s justified.
The move in the unemployment rate in July that just came out shows that that unemployment rate is already significantly above where the Fed thought it would be at the end of this year.
We see material progress on the lagging sticky bits of inflation like owners’ equivalent rent last month. And we’ve seen developed market central banks cutting in almost every other country. So the Fed is looking behind the curve. We think they will have to play catch up and a I said the historic precedent would suggest that bond yields have room to materially decline.
In the last week or so, they have come down to levels which are more consistent with where growth is trading. So we’re seeing encouraging progress on that front, but credit spreads themselves to us even with the recent move wider in the last couple of days aren’t looking particularly compelling value. The starting point as I said earlier was almost at all-time historic tights in credit spreads.
Credit has been lower beta than the moves we’ve seen in the equity market, particularly in very bubbly parts of the market like Japanese equities and US tech equities. Credit has been low beta. It has sold off in sympathy, but it’s not looking particularly compelling at the moment.
So with that being said, we sit here today with central banks across the developed world beginning to cut rates, even the Bank of England earlier this month.
We think the Fed will follow in September and they’re increasingly looking behind the curve and with that, the market regime has adjusted in an incredibly fast and ferocious manner,
The potential for much quicker and more aggressive rate cuts to start the cycle will make people reconsider the kind of investments that they’ve been focused on. So money market funds, short dated, longer credit positions obviously at risk in a market in which employment is beginning to deteriorate.
Employment is always the key catalyst for bond markets to price in a recession and we’ve seen that with a dramatic curve steepening that is associated with this bond rally in the last week or two.
So with that, I think it’s an interesting time for a lot of core bond funds which have been out of fashion in recent months or indeed in recent years. We’ve been in a four year bond bear market and history always suggested that bonds were due some outperformance post the last rate hike and as we entered rate cutting territory.
And with that, thank you for listening.
These are the views of the author at the time of publication and may differ from the views of other individuals/teams at Janus Henderson Investors. References made to individual securities do not constitute a recommendation to buy, sell or hold any security, investment strategy or market sector, and should not be assumed to be profitable. Janus Henderson Investors, its affiliated advisor, or its employees, may have a position in the securities mentioned.
Past performance does not predict future returns. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested.
The information in this article does not qualify as an investment recommendation.
There is no guarantee that past trends will continue, or forecasts will be realised.
Marketing Communication.
Important information
Please read the following important information regarding funds related to this article.
- An issuer of a bond (or money market instrument) may become unable or unwilling to pay interest or repay capital to the Fund. If this happens or the market perceives this may happen, the value of the bond will fall.
- When interest rates rise (or fall), the prices of different securities will be affected differently. In particular, bond values generally fall when interest rates rise (or are expected to rise). This risk is typically greater the longer the maturity of a bond investment.
- The Fund invests in high yield (non-investment grade) bonds and while these generally offer higher rates of interest than investment grade bonds, they are more speculative and more sensitive to adverse changes in market conditions.
- Some bonds (callable bonds) allow their issuers the right to repay capital early or to extend the maturity. Issuers may exercise these rights when favourable to them and as a result the value of the Fund may be impacted.
- If a Fund has a high exposure to a particular country or geographical region it carries a higher level of risk than a Fund which is more broadly diversified.
- The Fund may use derivatives to help achieve its investment objective. This can result in leverage (higher levels of debt), which can magnify an investment outcome. Gains or losses to the Fund may therefore be greater than the cost of the derivative. Derivatives also introduce other risks, in particular, that a derivative counterparty may not meet its contractual obligations.
- When the Fund, or a share/unit class, seeks to mitigate exchange rate movements of a currency relative to the base currency (hedge), the hedging strategy itself may positively or negatively impact the value of the Fund due to differences in short-term interest rates between the currencies.
- Securities within the Fund could become hard to value or to sell at a desired time and price, especially in extreme market conditions when asset prices may be falling, increasing the risk of investment losses.
- Some or all of the ongoing charges may be taken from capital, which may erode capital or reduce potential for capital growth.
- CoCos can fall sharply in value if the financial strength of an issuer weakens and a predetermined trigger event causes the bonds to be converted into shares/units of the issuer or to be partly or wholly written off.
- The Fund could lose money if a counterparty with which the Fund trades becomes unwilling or unable to meet its obligations, or as a result of failure or delay in operational processes or the failure of a third party provider.
- When interest rates rise (or fall), the prices of different bonds will be affected differently. In particular, bond prices generally fall when interest rates rise or are expected to rise. This is especially true for bonds with a higher sensitivity to interest rate changes. A material portion of the fund may be invested in such bonds (or bond derivatives), so rising interest rates may have a negative impact on fund returns.
Specific risks
- An issuer of a bond (or money market instrument) may become unable or unwilling to pay interest or repay capital to the Fund. If this happens or the market perceives this may happen, the value of the bond will fall. High yielding (non-investment grade) bonds are more speculative and more sensitive to adverse changes in market conditions.
- When interest rates rise (or fall), the prices of different securities will be affected differently. In particular, bond values generally fall when interest rates rise (or are expected to rise). This risk is typically greater the longer the maturity of a bond investment.
- Some bonds (callable bonds) allow their issuers the right to repay capital early or to extend the maturity. Issuers may exercise these rights when favourable to them and as a result the value of the Fund may be impacted.
- Emerging markets expose the Fund to higher volatility and greater risk of loss than developed markets; they are susceptible to adverse political and economic events, and may be less well regulated with less robust custody and settlement procedures.
- The Fund may invest in onshore bonds via Bond Connect. This may introduce additional risks including operational, regulatory, liquidity and settlement risks.
- The Fund may use derivatives to help achieve its investment objective. This can result in leverage (higher levels of debt), which can magnify an investment outcome. Gains or losses to the Fund may therefore be greater than the cost of the derivative. Derivatives also introduce other risks, in particular, that a derivative counterparty may not meet its contractual obligations.
- If the Fund holds assets in currencies other than the base currency of the Fund, or you invest in a share/unit class of a different currency to the Fund (unless hedged, i.e. mitigated by taking an offsetting position in a related security), the value of your investment may be impacted by changes in exchange rates.
- When the Fund, or a share/unit class, seeks to mitigate exchange rate movements of a currency relative to the base currency (hedge), the hedging strategy itself may positively or negatively impact the value of the Fund due to differences in short-term interest rates between the currencies.
- Securities within the Fund could become hard to value or to sell at a desired time and price, especially in extreme market conditions when asset prices may be falling, increasing the risk of investment losses.
- Some or all of the ongoing charges may be taken from capital, which may erode capital or reduce potential for capital growth.
- CoCos can fall sharply in value if the financial strength of an issuer weakens and a predetermined trigger event causes the bonds to be converted into shares/units of the issuer or to be partly or wholly written off.
- The Fund could lose money if a counterparty with which the Fund trades becomes unwilling or unable to meet its obligations, or as a result of failure or delay in operational processes or the failure of a third party provider.
Specific risks
4 minute watch
Key takeaways:
- The market environment is shifting with expectations that the US Federal Reserve (Fed) has been slow to act and may have to cut rates by 50 basis points at its September meeting.
- We have been saying for several months that lead economic indicators were weakening, particularly the more critical employment data, and that central banks needed to be cutting interest rates.
- The US 10-year Treasury yield is closely following the average path of the 1970s, suggestive of deeper declines in bond yields (and rises in bond prices) ahead if the historical path is maintained.