Central banks: Say hello to team tortoise and team hare
Following recent monetary policy announcements, Jenna Barnard, Co-Head of Global Bonds, differentiates between different central banks and how they are likely to respond to incoming economic data.
2 minute watch
Key takeaways:
- The different rate decisions by the US Federal Reserve (Fed) and the Bank of England are symptomatic of a different pace to interest rate cuts between North America and Europe.
- Changes to unemployment in North America have been more meaningful and central banks there are more responsive to unemployment, particularly the Fed given its dual mandate of price stability and full employment.
- The so-called “Fed put” is back as there is a renewed focus on downside risk to growth. This is potentially good for risk assets but also for core fixed income because with inflation tamed bonds are regaining their place as a diversifier in portfolios.
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.
Diversification neither assures a profit nor eliminates the risk of experiencing investment losses.
There is no guarantee that past trends will continue, or forecasts will be realised. Past performance does not predict future returns.
Recorded 19 September 2024
Core fixed income: Investment grade bonds issued by governments or companies.
Correlation: The relationship between two variables, i.e. how they move in relation to each other. A positive correlation means they move in the same direction, a negative correlation means they move in opposite directions.
Credit rating: A score given by a credit rating agency such as S&P Global Ratings, Moody’s and Fitch on the creditworthiness of a borrower. For example, S&P ranks investment grade bonds from the highest AAA down to BBB and high yields bonds from BB through B down to CCC in terms of declining quality and greater risk, i.e. CCC rated borrowers carry a greater risk of default.
Default: The failure of a debtor (such as a bond issuer) to pay interest or to return an original amount loaned when due.
Dual mandate: maintaining price stability and full employment.
ECB: European Central Bank, the central bank that determines monetary policy for the eurozone.
Fed put: A term used to describe the notion that the US Federal Reserve will undertake monetary stimulus such as cutting interest rates to prevent severe asset market declines. The word put comes from a derivative called a put option which gives the holder the right to sell a security at a specific price by a specific time, helping to limit losses during market falls.
Federal Reserve: The central bank of the US which determines its monetary policy.
Hedge: A security or asset class in a portfolio that offers an offsetting position to another investment, i.e. rises when the other falls and vice versa. These positions are used to help reduce or manage risk in a portfolio.
High yield: A bond that has a lower credit rating than an investment grade bond. Sometimes known as a sub-investment grade bond. These bonds carry a higher risk of the issuer defaulting on their payments, so they are typically issued with a higher coupon to compensate for the additional risk.
Inflation: The rate at which the prices of goods and services are rising in an economy. The Consumer Price Index (CPI) is a common measure.
Investment grade: A bond typically issued by governments or companies perceived to have a relatively low risk of defaulting on their payments. The higher quality of these bonds is reflected in their higher credit ratings.
Monetary policy: The policies of a central bank, aimed at influencing the level of inflation and growth in an economy. Monetary policy tools include setting interest rates and controlling the supply of money. Monetary stimulus refers to a central bank increasing the supply of money and lowering borrowing costs. Monetary tightening refers to central bank activity aimed at curbing inflation and slowing down growth in the economy by raising interest rates and reducing the supply of money.
Reaction function: this reflects how a central bank alters monetary policy in response to economic data, i.e. how much and how quickly it reacts.
Risk assets: Financial securities that may be subject to significant price movements (i.e. carrying a greater degree of risk). Examples include equities, commodities, property lower-quality bonds or some currencies.
Volatility: The rate and extent at which the price of a portfolio, security or index, moves up and down. If the price swings up and down with large movements, it has high volatility. If the price moves more slowly and to a lesser extent, it has lower volatility. The higher the volatility the higher the risk of the investment.
Yield: The level of income on a security, typically expressed as a percentage rate. For a bond, at its most simple, this is calculated as the annual coupon payment divided by the current bond price.
This is Jenna Barnard from the Global Bonds desk at Janus Henderson.
In the last day, we have had two monetary policy meetings. We have had the Federal Reserve in the US cut rates by 50 basis points, their first cut of this cycle. And the Bank of England followed up with an unchanged rate decision, following a 25 basis points cut in August.
It is quite interesting to compare and contrast these two central banks.
You are really getting a sense of a tortoise in the shape of the Bank of England and the ECB, who are cutting at a pace of about 25 basis points every three months. A very gradual process of removing policy restraint versus North America, where you have the likes of the Bank of Canada and the Federal Reserve in the US cutting with more urgency.
The Bank of Canada has actually cut three times, 25 basis points each time since June. And there is a debate about whether they go for 50 basis points in October.
The Federal Reserve are expected to cut at every meeting. And there is a debate about whether those cuts will be 25 or 50 basis points.
In North America, what is happening is you have seen a much more material rise in the unemployment rate and the central banks there are extremely reactive to the dual mandate.
So not only is inflation becoming yesterday’s news as it is across the developed world, but there is a sense that the labour market is at a tipping point in North America. And that means that the Fed put is back. The strike price for that put is unemployment increasing by 0.1% or 0.2% from here. And that has been taken very positively by risk assets.
For bonds, it also means that bonds will regain their place in a portfolio as a hedge, as a diversifier.
Focusing on downside risk to growth and unemployment. That’s wonderful for bond markets. The inflation shock and the positive correlation to risk assets in the last few years, as I said, is beginning to fade into the distance. So as we sit here and we compare these two central banks, we’re really getting this theme of tortoise and hare. Other central banks in the developed world, you know, like New Zealand, will fall somewhere in between.
So there is beginning to be a little bit of divergence in terms of reaction function. But the direction of travel is towards lower rates. And as I said, that’s beginning to cause a shift in the demand for core fixed income and hopefully a much more positive outlook for the next 6 to 12 months.
Related insights
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.
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.
- The Fund invests in Asset-Backed Securities (ABS) and other forms of securitised investments, which may be subject to greater credit / default, liquidity, interest rate and prepayment and extension risks, compared to other investments such as government or corporate issued bonds and this may negatively impact the realised return on investment in the securities.
Specific risks
2 minute watch
Key takeaways:
- The different rate decisions by the US Federal Reserve (Fed) and the Bank of England are symptomatic of a different pace to interest rate cuts between North America and Europe.
- Changes to unemployment in North America have been more meaningful and central banks there are more responsive to unemployment, particularly the Fed given its dual mandate of price stability and full employment.
- The so-called “Fed put” is back as there is a renewed focus on downside risk to growth. This is potentially good for risk assets but also for core fixed income because with inflation tamed bonds are regaining their place as a diversifier in portfolios.