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Fixed income | Core: Rates

Investment outlooks / Q4 2020
  • Future prospective returns in fixed income are as low as they’ve ever been, and look set to stay that way
  • Developed economies are liable to being held prisoner to a low (zero) rate environment for the foreseeable future due to their sensitivity to interest payment burdens.
  • Carry is now not enough to generate adequate returns, and thus a more active range trading approach is approached

Central banks have created conditions that have resulted in extremely troublesome fragilities at the heart of the world economy. First, it has led to ‘yield hunting’ among investors, who are forced to seek higher yields from riskier financial products. Secondly, it has led to a permanent central bank intervention in the financial markets, because without it a crash would surely occur. However, the limits of Central banks to influence the economy is being keenly felt, with the Fed chairman Powell calling for additional fiscal stimulus. fiscal stimulus delivered in 2020 is already unprecedented, but the question now becomes if this is a “one-off” or is continual fiscal stimulus is now the “new normal” response to any crisis as the effectiveness of monetary policy nears exhaustion. Signs are that the Fed is now at the end of the road, as rates have to be kept low not just for the next few years but potentially even longer due to the potentially crippling future interest burden. The problem for investors is that the prospective returns on everything are about as low as they’ve ever been and look set to stay that way.

Most financial downturns are caused by economic slowdowns, and they are managed with economic tools. This downturn was caused by a non-economic factor and as such cannot be fully cured through the application of economic stimulus despite the best efforts of central banks and governments. It should be noted that the fiscal packages seen at the onset of the pandemic should not really be counted as economic stimulus but rather economic support (to replace and maintain income in a lock-downed economy). Further debt-financed stimulus is likely since incomes for individuals as well as governments have dried up. In the short-term, a further fiscal package is required to continue supporting the economy, or we will see inflation expectations trend lower along with demand. However, evidence from Europe suggests that the debt burden created by such “decisive fiscal policies” in recessionary times not only stays and grows but will lead to rising taxes afterwards to “reduce the deficit” that hinder growth and job creation. This is clearly demonstrated by the latest Congressional Budget Office (CBO) projections (see chart below).

Click chart to expand. Source: Congressional Budget Office.

Policy support has resulted in a substantial expansion of government debt and central bank balance sheets, increasing the fiscal drag down the road and increased inflation risk in the longer term. The US debt burden is projected to be 104.4% of GDP by end of 2021. To put into context, this is higher than seen at the end of WW2, and by 2050 is projectected by the CBO to be at almost 200% (levels we associate with Japan, Italy and Greece).  It is not just governments that are increasing their debt burden. Credit is widely available, and bond issuance has reached record levels. This is shown by the fact that despite the biggest quarterly decline in US GDP on record, USD 345bn of high yield debt has been issued this year (prior record was USD 345bn in 2012). Not only does this debt (government and corporate) need to be refinanced in the future, but the interest component is a major factor that can determine whether the Fed can increase rates without derailing the economy.

Since the advent of the Volker-Greenspan era, the Fed has responded to each downturn by moving rates lower, with the result that each cycle ending in a lower interest rate high than seen before.  One of the consequences has seen the Fed adopting other policy tools to achieve its monetary goals (resulting in the growth of its balance sheet). We are now at a stage where the size of the US government debt leaves very little room for the Fed to manoeuvre. The dawning of this fact may have led to the conclusion of its recent policy review, shifting to “Average Inflation targeting” rather than targeting a specific level, that allows the Fed room to delay any rate hikes.

The confirmation of the lack of room to raise rates is highlighted by a report from the CBO, who do not expect the 10-year treasury yield to be higher than was last seen in 2018 for a decade. It is clear that any rise in treasury yields, as would be normally expected in an economic expansion, would lead to an ever growing Federal deficit as net interest payments increase. It is striking that the Federal deficit as a % of GDP in 2050 is expected to be -12.6%, about the same size as was introduced this year as a response to the Covid-19 pandemic. In 2050 it would be due to growth in net interest payments, not fiscal expenditures used to support or stimulate the economy. In 2050, 8.1% of GDP is projected to meet yearly interest, larger than the expected net revenue from both payroll and corporate income taxes combined (7%). Not only is the US projected to have more debt, but it is would also be growing its debt burden to refinance its obligations and pay its yearly interest bill. The obvious and political solution will be to enter a “Japanification” era of US debt by maintaining not only low rates (at zero) but also yield curve control (keeping the 10 year rate at 0.1%) until such a time as the US debt can either be inflated away (something “average inflation targeting” can help achieve) or via a gradual reduction in the debt to GDP ratio  if the US economy were to grow faster than the gross debt burdern. This would be aided by either a high birthrate or substantial net immigration (that is, more taxpayers), but the former seems optimistic and the latter unrealistic. Thus, there is little room for yields to move significantly higher with the US economy facing the drag from interest payments.

Click chart to expand. Source: Congressional Budget Office.

It is not only the US which has become more indebted. A similar picture is emerging for other central banks where now the sensitivity to an increase in rates affecting interest payments has to be seriously considered. Not only is the picture on a government level bleak, but corporates have also been increasing their debt burden, taking advantage of the current low cost of capital. We performed an analysis of US Investment Grade interest payments out to 2050. Like the US government, these companies will see their interest servicing costs almost triple in a situation where their debt remains at today’s levels. Corporate cashflow would just be increasing diverted to servicing these costs making likelihood of zombie companies more likely. Developed economies are therefore liable to being held prisoner to a low (zero) rate environment in the future due to their sensitivity to these interest payment burdens. The eventual shift to central bank tightening following such extreme accommodative stance could be a shock that sparks a major financial crisis, similar to that experienced by some emerging markets in the past.

Click chart to expand.

We see little room for any further cuts in rates, especially in US and Europe. The Fed insists it won’t move to negative rates and it is hard to argue that negative / zero rates have rekindled any meaningful economic growth in Europe or Japan. Both the government and corporate debt levels are approaching a level that means that the room to meaningfully hike is also lower (with the initial taper tantrum of Q4 2018 being a clear reminder of the effects). Of course, inflation may be pushed higher by the combination of fiscal stimulus and easy money. However, we note that governments have been trying to create 2% inflation for years without success (Japan and Europe are prime examples), and thus we see a Japan scenario for many governments with rates on hold.  With a high likelihood of range trading environment for bonds going forwards not only in the US but also in Europe and UK, the historically low prospective returns from fixed income are likely. As such, we advocate an active range trading approach, looking to add duration when the top end of a range is close and then lowering exposure when it comes back to the lower end of the range. Simply put, carry will not be enough and a prudent form of active management trading will be required.

US election

The upcoming US election on November 3rd is probably the biggest event happening in Q4 2020 and will set the range for the remainder of the year. Our analysis means that we expect US treasuries to widen out in 3 of the 4 scenarios. The expected outcome from the latest polls suggests a “blue wave”, where the US 10-year yields would move into a range of 80bp to 100bp. The only scenario for lower yields is one that would be troubling for risk assets – namely a contested election, where we would expect yields to test the lows of the year once more.  Positioning wise, from a tactical perspective should the 10 year be greater than 80bp in the week leading up to the election, we would have no qualms about adding some duration to our portfolios to hedge against a contested election safe in the knowledge that it is also within our expected range for the “blue wave”, with a potential reward of 40bp in tightening.

Click table to expand.

US positioning

Signals from the Fed suggest that rates will not move until 2024, and this is confirmed by the updated policy strategy review which heralded “average” inflation targeting and emphasized its commitment to achieving a tight labor market that brings “broad-based and inclusive” benefits. Since the beginning of 2010 the Fed’s favoured measure on inflation, the core personal consumer expenditure deflator, has been at or above 2% in just 13 months – so a hit rate of one in 10 – posting an average of 1.6% year on year over the past decade. Anecdotal evidence suggests that to get the desired “average” inflation target of 2% means that rates may take even longer to hike than expected. In addition, we have had a bold statement from Fed President Kaplan stating that if long rates were to rise then he would be inclined to buy more bonds, thereby putting an effective ceiling on long-rates. So, in essence, the Fed has already adopted de facto yield curve control even if this has not been stated as an outright policy of the Fed. Our medium-term view does see an eventual move into the 80-100bp range for the 10yr, and we expect this range to come to fruition in the coming quarter.

With the risk reward ratio for holding government bonds terrible, due to the lack of a yield we prefer to be underweight US government bonds (looking to only hold 10 year and 30 year paper). To balance this off, we also look to hold short dated IG paper where companies have adequate short term liquidity to meet the upcoming debt maturities. This barbell approach allows us to enjoy a modicum of yield whilst keeping our overall portfolio duration down. We look to actively trade the 30 year part of the curve based on the ranges we have previously mentioned. We continue to prefer to own solid IG rated companies which benefit from not only the low rate environment but also the support provided by the Fed.  In High yield, we note that there is yield on offer but prefer to be selective in our name selection noting that the damage to the economy / main street will cause repercussions to various HY sectors.

EUR positioning

The ECB is expected to ease its monetary policy stance again in December with the most likely form of easing being additional asset purchases. We also take note of ECB Chief Economist Lane’s Jackson Hole speech where he signalled that the post-pandemic policy stance would likely need to be recalibrated because of the low inflation problem, signalling more asset purchases. Lastly, the EUR750bn EU Recovery Fund (5.25% of EU GDP) is expected to obtain its full political and legal authorisation at the end of 2020. The combination of all these factors should limit the potential for any movement in core rates and leads to a potentially narrow trading range as evidenced by the narrow range yields have traded in the last 90 days (see chart below).

With most of the core countries offering negative yields, we continue to prefer to hold Italy (where we note that the CBs are absorbing all projected supply for 2020) and Greece despite the yield dropping 1% for both. We expect yield seeking investors will continue to support the peripheries in the absence of any yield available elsewhere. Although full-economy lockdowns were temporary and conditions are now much less restrictive than in early-Q2, the ramifications still need to be seen. Most businesses will not have been able to fully re-capture the lost activity and in sectors such as transportation and leisure, revenues are likely to stay depressed for some time to come. As such we hold a preference for solid IG over HY issues.

GBP positioning

The two biggest risks to the UK outlook are a second wave and a no deal Brexit. With Covid-19 becoming more prevalent across the UK once again and the uncertainty that it brings and a rising possibility of a no deal Brexit, the Bank of England (BoE) has made it clear that negative rates (NIRP) are now ‘in the toolkit’. Whilst we do not expect NIRP to be introduced this quarter, it is now a possibility for introduction in 2021. With the “V-shaped” recovery now highly unlikely, we see on-going monetary stimulus limit any potential sell-off. A combination of GBP 100bn more QE (expected in November) combined with NIRP expectations means that we could see the 10year gilt trade below 0%. With low yields in the government bond market offering little carry, we continue our strategy of favouring IG rated global issuers which will benefit from the credit spread but also any move lower led by government bond yields. Once more we see a downward trending tight range for UK government bonds and prepare to sell holdings into any strength.

Past performance is not a reliable indicator of future returns. Forecasts are not a reliable indicator of future returns. If the information is not listed in your base currency, then the result may increase or decrease due to currency fluctuations.

If not otherwise indicated, all graphs are sourced from Dolfin research, October 2020.

For more information please read our disclaimer.


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Fixed income | Satellite: Credit
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