Paul Brain, Newton's investment leader for fixed income, looks at bond investors' hyperfocus on central bank signals in anticipation of a potential tapering of the Fed's asset purchases. Paul discusses the main factors that might drive bond yields higher over the next months as well as what could prevent them from drifting too high as we enter the final quarter of the year.
The Lords of Finance are back in control again. In his award-winning book, Lords of Finance: The Bankers Who Broke The World, Liaquat Ahamed describes the period following the First World War, when the four most powerful men in finance were the central bankers of the U.S., U.K., France and Germany. In our view, world markets today are also in the grips of the central banks, with no other factor wielding so much influence: as central banks set the price of money and control the flow of funds, we see that investors have little choice but to play along.
What happens when these Lords of Finance decide enough intervention is enough? We had a taste of that when, in May, the U.S. Federal Reserve outlined the reasons for reducing its influence on financial markets through reduced purchases of bonds, which could possibly begin in the fourth quarter.
Following the First World War, as detailed by Ahamed, the "Lords" were united in their fear of inflation, and their common vision was to turn back the clock and return the world to the gold standard. Their legacy was the Great Depression and ultimately a period of high inflation and, some may argue, flagstones in the groundwork for the Second World War.
This Time Is Different!
Since the Fed's announcement of May 22 we have witnessed much speculation about the tapering of its quantitative easing program (QE), and the likelihood that it will raise bond yields and be negative for "risk assets." As a result, an adjustment phase has been experienced in all financial assets that have been buoyed by speculation over continued QE. We suggest this has created some anomalies.
For instance, if we take the Fed at their word on maintaining ultra-low interest rates, why should the short end of the U.S. yield curve have priced in a rate rise? Short-dated bond yields have risen by as much as those at the longer end, despite being anchored by a "zero interest rate" policy. Suggesting, perhaps, that the markets had misinterpreted the Fed's previous guidance, the Fed Chairman pointed out the error of their ways and stated that monetary policy would remain accommodative for a while yet. The other anomaly is that bond markets around the world have fallen (yields have risen), either in line with, or in some cases by more than, U.S. bonds. If anything, the economic statistics from these other economies have been weaker, led in part by concerns over Chinese growth.
So, apart from a rise in bond yields, what has changed over the last few weeks? The Fed maintains that any reduction in the pace of Q.E. is dependent on data: recently, we have observed that G10 economic growth is recovering gradually, but Asia and China seem to be slowing. The concern about China, in addition to the strength of the U.S. dollar, is weighing on commodity prices. Furthermore, longer-term concerns about emerging markets appear to have escalated: it is of little surprise, then, that emerging-market debt has been one of the worst-performing asset classes over the last few months.
U.S. bond yields have reached levels at which they are strongly influencing mortgage rates, but the momentum in the U.S. housing market suggests to us that yields may have to rise even higher before they turn the market.
In January, we identified a yield of 2.5% for the 10-year Treasury as a point where the market should pause. From here, we think that yields are likely to drift higher if employment figures continue to improve, or until we see clear evidence that higher yields are having a negative effect on the economy.
How far could yields rise in this environment? Or rather, how far will they be allowed to rise? The absence of sharp increases in the federal funds rate means we are not in the same situation as in 1994; the Federal Reserve raised rates by 3% between February 1994 and February 1995, the U.S. 10-year yield went from 5.84% to 7.93%, and inflation expectations rose sharply. We think 10-year U.S. yields are likely to stay in the 2.5% to 3.0% range in the near term. We expect that the market will be influenced by a number of opposing forces over the summer before being able to rally later in the year.
The following is a list of what we think will be pushing and pulling yields. First, the reasons why U.S. Treasury yields may gradually rise during the rest of the summer:
- In our view, the asset class is very over-owned, and is therefore vulnerable to fund outflows. Much of this could already be reflected in the price as, in light of recent market events, many funds may now be more defensively positioned and may have anticipated further fund flows. But we observe that there is usually a delay between initial price moves and flows, and we anticipate less buying activity by funds, and possibly a bit more selling.
- We think that the market will continue to anticipate less bond-buying by the Fed, particularly as employment data continues to improve, causing Treasuries to remain under pressure.
- We expect that the volume of emerging-market central bank buying of U.S. Treasuries may be anticipated to be lower in the future. In particular, if the Chinese decide that they too need a weak currency, we think there would be less need for them to recycle their current account surplus into dollar assets.
- We think there may be lower "safe-haven" demand from investors concerned about a eurozone crisis, who may be lulled into a false sense of security ahead of the German federal election on September 22.
- Finally, while perhaps not really a negative for Treasuries but certainly not a support as yet, we assert that it may take a bigger rise in mortgage rates to take the froth out of the housing market.
On the other hand, as we head towards the fourth quarter and as yields are higher, we find there are a number of factors that could prevent yields rising too high:
- Inflation is lower, so real (i.e., inflation-adjusted) yields will be increasingly attractive. Investors may, we believe, prefer the certainty of positive bond real yields to the vulnerability of equity income.
- Although U.S. growth may be stabilizing, there are signs (including data from the International Monetary Fund) that suggest that other areas may be slowing fast. Eventually, we think this will influence the U.S. economy.
- The Chinese economy in particular seems to us to be slowing, albeit that support from the authorities could lead to less money being available for authorities to spend on U.S. Treasuries. The eurozone could still be vulnerable, but we think it is unlikely to wobble too precariously before the German election later this year.
- The Federal Reserve will still be buying U.S. Treasuries even if they begin the process of reducing their rate of purchases.
- The broader U.S. economy is still, according to recent ISM data, not very robust.
On balance, in the absence of a significant shock, we would expect yields to rise steadily in line with improvement in the U.S. employment market. Accordingly, if employment gains fizzle out, we think yields would stop rising. The fragility of U.S. and global growth will, we believe, limit the rise in yields from here. We think the current debt-burdened global economy would struggle to cope with new government funding (in the U.S. at least) at a rate above 3%.
This leads us back to the Lords of Finance. We think they won't allow rates to rise too much because the world simply can't afford it. The Japanese central bank was disappointed by the market's reaction to their intervention policies in April and managed to convince investors to push Japanese government bond yields back down (prices up). Both the Bank of England and the European Central Bank have reminded the fickle bond market that monetary policy is unlikely to change for a very long time. Finally, the Fed has also felt the need to remind the market about how accommodative monetary policy is. One could also add the Chinese authorities to this list of market manipulators, following their attempts to fiddle with interbank rates in recent weeks.1
The age of the Lords of Finance is with us again. The membership of the group has changed a little, but the need to keep a lid on borrowing costs in the face of high debt burdens suggests to us that we are stuck with this form of influence for some time yet.
1 "When Liquidity Meets Control in China," Financial Times, June 18, 2013.
BNY Mellon Investment Management is one of the world's leading investment management organizations and one of the top U.S. wealth managers, encompassing BNY Mellon's affiliated investment management firms, wealth management organization and global distribution companies. BNY Mellon is the corporate brand of The Bank of New York Mellon Corporation and may also be used as a generic term to reference the Corporation as a whole or its various subsidiaries generally. · The statements and opinions expressed in this document are those of the authors as of the date of the article, are subject to change as economic and market conditions dictate, and do not necessarily represent the views of BNY Mellon, BNY Mellon Asset Management International or any of their respective affiliates. This document is of general nature, does not constitute legal, tax, accounting or other professional counsel or investment advice, is not predictive of future performance, and should not be construed as an offer to sell or a solicitation to buy any security or make an offer where otherwise unlawful. The information has been provided without taking into account the investment objective, financial situation or needs of any particular person. BNY Mellon Asset Management International Limited and its affiliates are not responsible for any subsequent investment advice given based on the information supplied.
Past performance is not a guide to future performance. The value of investments and the income from them is not guaranteed and can fall as well as rise due to stock market and currency movements. When you sell your investment you may get back less than you originally invested. · While the information in this document is not intended to be investment advice, it may be deemed a financial promotion in non-U.S. jurisdictions. Accordingly, where this document is used or distributed in any non-U.S. jurisdiction, the information provided is for use by professional and wholesale investors only and not for onward distribution to, or to be relied upon by, retail investors. · Products or services described in this document are provided by BNY Mellon, its subsidiaries, affiliates or related companies and may be provided in various countries by one or more of these companies where authorized and regulated as required within each jurisdiction. This document is not intended for distribution to, or use by, any person or entity in any jurisdiction or country in which such distribution or use would be contrary to local law or regulation. This document may not be distributed or used for the purpose of offers or solicitations in any jurisdiction or in any circumstances in which such offers or solicitations are unlawful or not authorized, or where there would be, by virtue of such distribution, new or additional registration requirements. Persons into whose possession this document comes are required to inform themselves about and to observe any restrictions that apply to the distribution of this document in their jurisdiction. The investment products and services mentioned here are not insured by the FDIC (or any other state or federal agency), are not deposits of or guaranteed by any bank, and may lose value. · This document should not be published in hard copy, electronic form, via the web or in any other medium accessible to the public, unless authorized by BNY Mellon Investment Management International Limited.
In Australia, this document is issued by BNY Mellon Investment Management Australia Ltd (ABN 56 102 482 815, AFS License No. 227865) located at Level 6, 7-15 Macquarie Place, Sydney, NSW 2000. Authorized and regulated by the Australian Securities & Investments Commission. · In Brazil, this document is issued by BNY Mellon Serviços Financeiros DTVM S.A., Av. Presidente Wilson, 231, 11th floor, Rio de Janeiro, RJ, Brazil, CEP 20030-905. BNY Mellon Serviços Financeiros DTVM S.A. is a Financial Institution, duly authorized by the Brazilian Central Bank to provide securities distribution and by the Brazilian Securities and Exchange Commission (CVM) to provide securities portfolio managing services under Declaratory Act No. 4.620, issued on December 19, 1997. · Securities in Canada are offered through BNY Mellon Asset Management Canada Ltd., registered as a Portfolio Manager and Exempt Market Dealer in all provinces and territories of Canada, and as an Investment Fund Manager in Ontario. · In Dubai, United Arab Emirates, this document is issued by the Dubai branch of The Bank of New York Mellon, which is regulated by the Dubai Financial Services Authority. · If this document is used or distributed in Hong Kong, it is issued by BNY Mellon Investment Management Hong Kong Limited, whose business address is Suites 1201-5, Level 12 Three Pacific Place, 1 Queen's Road East, Hong Kong. BNY Mellon Investment Management Hong Kong Limited is regulated by the Hong Kong Securities and Futures Commission and its registered office is at 6th floor, Alexandra House, 18 Chater Road, Central, Hong Kong. · In Japan, this document is issued by BNY Mellon Asset Management Japan Limited, Marunouchi Trust Tower Main Building, 1-8-3 Marunouchi Chiyoda-ku, Tokyo 100-0005, Japan. BNY Mellon Asset Management Japan Limited is a Financial Instruments Business Operator with license no 406 (Kinsho) at the Commissioner of Kanto Local Finance Bureau and is a Member of the Investment Trusts Association, Japan and Japan Securities Investment Advisers Association. · In Korea, this document is issued by BNY Mellon AM Korea Limited for presentation to professional investors. BNY Mellon AM Korea Limited, 29F One IFC, 10 Gukegeumyung-ro, Yeongdeungpo-gu, Seoul, 150-945, Korea. Regulated by the Financial Supervisory Service. · In Singapore, this document is issued by The Bank of New York Mellon, Singapore Branch for presentation to professional investors. The Bank of New York Mellon, Singapore Branch, One Temasek Avenue, #02-01 Millenia Tower, Singapore 039192. Regulated by the Monetary Authority of Singapore. In Singapore, this document is to be distributed to Institutional Investors (as defined in the Securities and Futures Act, Chapter 289 of Singapore) only. · This document is issued in the UK and in mainland Europe, by BNY Mellon Asset Management International Limited, 160 Queen Victoria Street, London EC4V 4LA. Registered in England No. 1118580. Authorized and regulated by the Financial Conduct Authority. · This document is issued in the United States by BNY Mellon Investment Management.
BNY Mellon owns over 95% of the parent holding company of The Alcentra Group, which is comprised of the following affiliated investment advisers: Alcentra, Ltd and Alcentra NY, LLC. · BNY Mellon ARX is the brand used to describe the Brazilian investment capabilities of BNY Mellon ARX Investimentos Ltda. · BNY Mellon Western FMC, Insight Investment and Meriten Investment Management do not offer services in the U.S. This presentation does not constitute an offer to sell, or a solicitation of an offer to purchase, any of the firms' services or funds to any U.S. investor, or where otherwise unlawful. · BNY Mellon Cash Investment Strategies is a division of The Dreyfus Corporation. · BNY Mellon Western Fund Management Company Limited is a joint venture between BNY Mellon (49%) and China based Western Securities Company Ltd. (51%). The firm does not offer services outside of the People's Republic of China. · BNY Mellon owns 90% of The Boston Company Asset Management, LLC and the remainder is owned by employees of the firm. · BNY Mellon owns a 19.9% minority interest in The Hamon Investment Group Pte Limited, the parent company of Blackfriars Asset Management Limited and Hamon Asian Advisors Limited both of which offer investment services in the U.S. · Services offered in the US, Canada and Australia by Pareto Investment Management Limited under the Insight Pareto brand. · The Newton Group ("Newton") is comprised of the following affiliated companies: Newton Investment Management Limited, Newton Capital Management Limited (NCM Ltd), Newton Capital Management LLC (NCM LLC), Newton International Investment Management Limited and Newton Fund Managers (C.I.) Limited. NCM LLC personnel are supervised persons of NCM Ltd and NCM LLC does not provide investment advice, all of which is conducted by NCM Ltd. Only NCM LLC and NCM Ltd offer services in the U.S. · BNY Mellon owns a 20% interest in Siguler Guff & Company, LP and certain related entities (including Siguler Guff Advisers LLC). · BNY Mellon Asset Management International Limited and any other BNY Mellon entity mentioned above are all ultimately owned by BNY Mellon, unless otherwise noted.
© 2013 The Bank of New York Mellon Corporation. All rights reserved.