My inbox was full of emails last week from strategists pushing up their US treasury yield forecasts for 2022 and 2023. I guess that is not surprising given the Consumer Price Index (CPI) print, which showed US inflation at 7%, and a more hawkish message from the US Federal Reserve.
One thought piece caught my attention – setting out how low interest rates in the post Great Financial Crisis period (GFC 2008-now) had caused a collapse in productivity in the US, euro area and UK and that this was to be expected as, historically, other periods of ultra-low rates had the same outcome. The argument continued that low rates do not promote growth, just dampen productivity, and thereby lower growth potential; this results in more calls for the maintenance of ultra-loose monetary policies. This circle is eventually broken by the onset of inflation to which central banks are ultimately forced to react. It could be argued that the last 13 years have been characterised by disinflation – not inflation. But the premise is that the GFC, ongoing euro crises and Covid have masked the underlying trend. The conclusion is that inflation is out of the bag and that the long end of bond markets look toxic.
So where could bond markets go? At RLAM we have nudged up our government bond yield forecasts, based on higher short-term rates. On our regression analysis, five-year rates look a bit expensive, 10 years more so and 30-year yields look materially overpriced. So why are our portfolios not more aggressively short duration?
The answer is in another article I read – which sets out an alternative ending. Put simply, financial markets will not allow rates to go up too much, and probably by less than many forecasts are now pencilling in – before they have a meltdown. It used to be said that the US treasury market could intimidate everybody – the reality today is equity and credit markets are the new intimidators.
It is an irony that since the Bank of England independence in 1997 there has been increased aversion to letting market forces work. I perhaps should not link this to the move to independence – as it is an observation that applies to most developed market central banks. The desire to avoid recessions, with their consequent economic and social impacts, sounds a worthy objective. The problem is that the healthy aspects of recession – the failure of weak business models and the success of the innovative – have been diluted. In hindsight, the recovery from the GFC may be seen as the lost opportunity. Through the best of intentions, monetary policy was kept too loose and even mild downturns were seen as economically, or perhaps more relevantly socially, unacceptable.
Government bonds and cash
Another week of mixed data. In the UK, stronger than expected growth was recorded in November, with the level of GDP now back above pre-pandemic although consumer-facing services output is still well below pre-pandemic levels – by about 5%. There was a bounce in industrial production as car output rebounded while higher construction activity reflected improved availability of inputs, with mild weather probably helping too.
In the US, December retail sales and industrial production were both lower than expected. The weak performance of retail sales is consistent with households having pulled forward Christmas spending and was reflected in a lower University of Michigan Consumer Confidence reading. The US savings rate is now back to pre-pandemic norms, indicating less scope to support spending.
Yields on 10-year bonds were not greatly changed on the week, rallying in the early part but giving ground later on. Implied inflation was a touch lower in the US and a bit higher in the UK. Sterling continued to strengthen, with a trade weighted index at a five-year high.
The flurry of activity seen in investment grade markets continued last week. There was an interesting issue from London & Quadrant (L&Q), one of the UK’s largest Housing Associations. The issue was a sustainability linked bond and represents another step in the evolution and maturing of the labelled bond market. First, we saw Green bonds, focusing on the use of proceeds; these have evolved but we still see flaws. The development of sustainability linked bonds, where the focus is on hitting specific targets set out in bond documentation, with penalties for failure, is a move forward.
In the case of L&Q there were three criteria, relating to reduction in Scope 1 and Scope 2 carbon emissions, the volume of affordable housing built and energy efficiency within their housing stock. A key requirement is to set criteria at the right level – both stretching and credible. While definitely going in right direction, one challenge we had was that the emissions reduction goals were not stretching enough compared to their baseline year, highlighting the importance of not taking these targets at face value. Nevertheless, we welcome their initiatives and see this as part of a journey for the bond markets towards more credible ESG outcomes. Within our Sustainable credit portfolios, we typically have an allocation of 15-20% to Housing Associations debt – and the new issue neatly fitted into these strategies.
Past performance is not a reliable indicator of future results. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.