November 2019

Themes in Focus

Fixed Income Leadership

Key Takeaways

  • The U.S. yield curve has been a good indicator of recession when accompanied by other factors such as a weak consumer, a decline in inflation, falling jobs or weak employment. However, with few of these signs present, the curve appears idiosyncratic at this juncture.
  • Negative-yielding debt has soared to roughly $15 trillion* worldwide. This is not merely a symptom of weak economic growth, but is also due to insufficient demand and excessive debt loads, as well as central banks falling short with their policy toolkit.
  • Against this backdrop, investors may question whether bonds still have a place in their portfolios. While their income component is clearly diminished, we believe bonds still play a valid role as a source of diversification, particularly in risk-off markets.

Jim Cielinski, Global Head of Fixed Income, provides his perspective on some of the key macroeconomic factors that are driving fixed income markets.

View Transcript

Is the U.S. Yield Curve still a reliable indicator that recession is coming?

I think the U.S. Yield Curve has been overhyped as a recession indicator. It is a great indicator when accompanied by other things, like a weak consumer or let’s say falling inflation, falling jobs or weak employment. We see none of those and so I think you have to look at the curve and say it is a little bit idiosyncratic in this particular phase.

On top of the weak inflation expectations, the weak growth expectations, we know what the toolkit for central banks is and it is often buying more bonds, lowering rates. And these things I think when you look at it in conjunction with those economic variables are really powerful in depressing the yield curve.

Will the ECB’s pursuit of negative rates be effective, or is it time for fiscal policy to pick up the stimulus baton?

The markets are telling us that fiscal policy must come to the rescue. The ECB will do what it has to do, it will pull out the same bag of tricks that it did in the last cycle and that is just because they can’t do anything else within their remit. Will it be effective? I doubt it. It wasn’t that effective the first time. And negative rates have some, I think, really bad side effects. The bank profitability issue, that credit creation function which originates in the banking system is broken and actually gets even more broken with negative rates. And ultimately, that is what you need to get the economy out of this weak spot.

How did we arrive at $15 trillion of negative-yielding debt worldwide?

It is astonishing that we are looking at so much debt that has a negative yield. This has been 30 years in the making, so it is not just a symptom of weak growth today. This is insufficient demand and excessive debt loads that when combined, you just don’t see the credit creation needed in today’s economy to send rates higher. And so with central banks falling short with their policy toolkit, I think it is the combination of all this, that has led to negative rates. These are structural in nature, so it is difficult to see these suddenly reversing except on a short-term cyclical basis. So it seems quite odd, but as long as those conditions stay with us, negative rates will stay with us as well.

What are the implications for market liquidity as highly accommodative monetary policy returns?

Easy money is often associated with more liquidity, but I think it is important to realize that is in the economy. With markets, what that often means is that central banks distort markets. They, through quantitative easing, buy a lot of the supply. And in fact, that reduces market liquidity. Now it is important to remember that does not mean markets always go down, illiquid doesn’t mean weak markets. Illiquid can also mean rising prices just as that buying distorts markets and pushes prices higher. But I think market liquidity remains very challenging in the coming year.

You are going to have these volatile spikes in the market, both up and down. Be ready for those, but don’t overreact. I think it is quite easy to have fear overwhelm your decision making in these periods. but most of these you should really wade through and ask, “Is it a true shift in fundamentals or is it a market liquidity event?” If it is the latter, stay calm.

Given the landscape, do bonds still have a place in investors’ portfolios?

When I look at the valuation of bonds today, it is hard to argue that zero gives a lot of upside potential. That said, bond yields can move more negative and with that capital appreciation can still exist. But I think people do need to feel like their return expectations should be lower. So that is what I would caution people to look at and identify what they are in bonds for.

Historically, it has been about income and it has been about portfolio diversification. With low yields, I think it is fair to say that income component is quite low. You can still see it in some places though, emerging market debt, corporate debt, high yield. And with low default levels, that may not be a bad place to hang out to get that income. But the return potential is more limited. That said, I have heard for years that bonds didn’t have any diversification potential left and when you do get risk-off environments, bonds rally. So I still think they serve that purpose.

And I think with that, you start looking at the appropriate outcomes of different fixed income products and you will find when you do that most fixed income products still have a very valid role in a broader portfolio.

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C-0919 26491 12-30-20

Is the U.S. yield curve still a reliable indicator that recession is coming?

The U.S. yield curve has been a good indicator of recession when accompanied by deterioration across other factors such as a weak consumer, falling inflation or weakness in employment data. The evidence here is spotty. At the current juncture, the curve is probably a good indicator of a slowdown, and we are living through that now, but a recession – no.

The curve is a bit idiosyncratic in this particular phase, with some aspects of curve behavior in this cycle driven by central banks. On top of weak inflation expectations and weak growth expectations, we know that the toolkit for central banks tends to be buying more bonds and lowering rates. These things, when you look at them in conjunction with the economic variables, are powerful factors in depressing the yield curve.

Will the ECB’s pursuit of negative rates be effective, or is it time for fiscal policy to pick up the stimulus baton?

The markets are telling us that fiscal policy must come to the rescue. Still, the European Central Bank (ECB) will do what it has to, likely by pulling out the same bag of tricks that it did in the last cycle, simply because it cannot do anything else within its remit. Is it likely to be effective? I don’t think so, largely for the reasons it was ineffective the first time. Additionally, negative rates have some unfortunate side effects, such as bank profitability. The credit creation function, which originates in the banking system, is broken and breaks down further with negative rates. And ultimately, private credit creation is what is needed to pull the economy out of this weak spot.

How did we arrive at roughly $15 trillion of negative-yielding debt worldwide?

That is an astonishing figure, but the path to negative rates has been a long one, 30 years in the making. It is not just a symptom of weak growth today. A stretch of insufficient demand coupled with excessive debt loads have hampered the credit creation needed in today’s economy to send rates higher. That coupled with ineffective central bank policy has led to negative rates. We know central banks are lowering rates today, and they don’t have a lot of other tools in the toolkit. Once they reach zero, buying debt, capping rates or continuing with quantitative easing (QE) programs for as far as the eye can see is really their only available tactic.

These issues are structural in nature, so it is difficult to see a sudden reversal, except perhaps on a short-term cyclical basis. It seems quite odd to some, but negative rates are here to stay as well.

What are the implications for market liquidity as highly accommodative monetary policy returns?

Easy money is often associated with more liquidity, but that is an economic phenomenon. With markets, accommodative central bank policy often distorts markets. Through QE, supply is absorbed, which, in fact, reduces market liquidity. However, it is important to remember: illiquid does not mean weak. Illiquidity can also mean rising prices as the asset purchases distort markets and drive prices higher.

With QE serving as one of the primary tools at central bankers’ disposal, I think market liquidity remains challenging in the coming year. Investors should be ready for volatility spikes, both up and down, but shouldn’t overreact. It is quite easy for fear to overwhelm decision making in these periods, but a more prudent approach is to focus on the medium- to long-term horizon. Most of these events you should wade through and ask, “Is it a true shift in fundamentals or is it a market liquidity event?” If it is the latter, stay calm.

The reality is that return expectations should likely be lower. I recommend investors take a hard look at their return expectations, and, equally as important, assess why they own bonds.”

Given the landscape, do bonds still have a place in investors’ portfolios?

When I look at the valuation of bonds today, it is hard to argue that zero gives a lot of upside potential. That said, bond yields can move more negative, and with that, capital appreciation can still exist. The reality for investors, though, is that return expectations should likely be lower. I recommend investors take a hard look at their return expectations, and, equally as important, assess why they own bonds. As a bond investor myself, I often start by asking how much income do I want, how much volatility can I withstand and how much diversification do I want relative to the other assets in my portfolio?

The income component of bonds is quite low. However, there are still pockets where income can be found, particularly if investors are willing to accept some level of volatility: emerging market debt, investment-grade corporate debt and high yield. Default levels remain low, which helps to keep some of these asset classes appealing. Securitized credit, too, can offer some good, relatively defensive sources of yield. But, without a doubt, nominal return potential across the board is more limited.

In terms of diversification, I have heard for years that bonds no longer offer diversification benefits. Yet, in risk-off environments, bonds rally, leading me to believe they do still serve that purpose. A look across the appropriate outcomes of different fixed income securities suggests that most fixed income products still have a valid role in a broader portfolio

Diversification neither assures a profit nor eliminates the risk of experiencing investment losses.

*Source: Bloomberg, Bloomberg Barclays Global Aggregate Negative Yielding Debt, Market Value in trillions of USD, at 30 September 2019