David Roberts

Why we think the market is wrong about long-term rates

David Roberts

There’s a general perception that the bond market has had a really tough time so far in 2021, but this is not necessarily the case. Yes, a lot of bonds have sold off as some volatility has returned to the market recently, but these are mostly short-duration, high credit quality bonds.

Overall, the Bloomberg Global Aggregate (US$ hedged) Index of global bonds has generated a fairly flat return year-to-date. By our reckoning, around two thirds of the market – longer duration and lower quality – is positive in capital terms year-to-date.

Why are short-dated bonds selling off while longer-duration bonds are rallying in price? Well, central banks are thinking about raising rates because inflation globally is off the charts. They believe that small rate rises now will curb consumption and borrowing and prevent more rate rises in the future.

The market, however, thinks that any tightening in monetary policy will choke off economic growth and will quickly be reversed by central banks towards the end of 2023.

Simplistically, the bond market’s thesis is that earlier rate rises will lead to a lower peak in rates further down the line. So short-dated bond yields have moved up to reflect increased expectations of rate rises soon, but longer-dated bond yields have dropped as investors think that, ultimately, rates will end up being lower than previously thought.

This yield curve phenomenon is known as a twist, and it is illustrated below in the case of the US curve through October.

US Yield Curve Moves 

The green line shows the yield curve at the start of the month and the gold line represents the curve at the end of October. While yields at the 3-year tenure moved up by about 25 basis points, the 30 year yield dropped by 10 basis points.

With many G7 central banks on the brink of raising rates, the bond market seems to be shouting that this is a mistake. Most investors believe that economies are not strong enough to withstand tighter monetary policy and that rate rises will be reversed.

We disagree. We don’t see rate rises as being a potential policy mistake; our view is that they are needed and will not destroy economic momentum.

Supply chain disruption, a reduction in globalisation and local tariffs to trade are here for the foreseeable future. Central banks should have raised rates a year ago to offset the massive government spending we have seen.

Although the next couple of years is likely to see high inflation and low real growth, the medium term conditions are now in place for a sustained boom in real growth. This won’t match the levels of growth seen in the ‘80s or ‘90s, but with excess savings boosting consumption, an accompanying tailwind in wages and rapidly falling unemployment, a real growth rate in developed market economies nearer 2% than 1% looks eminently achievable.

Couple this with continued sticky inflation and we are of the firm belief that rate rises are necessary.

Our contrarian position on the direction of interest rates has fed through to the positioning of our strategic funds. Relative to the peer group, we think the funds have a lot less duration risk and lower allocation to low-quality corporate credit.

This positioning should prove valuable if we are right about the economic outlook. Specifically, we think the inflation surge will continue, to 7% in the UK, 5% in Germany and with the US moderating to 4%. Central banks cannot ignore this and we think they would then raise rates amid ongoing consumer spending, de-globalisation and supply chain bottle necks. If this happens, yields will rise and we think longer-dated bonds will bear the brunt of the pain with yields rising the most.

Strategically, we are therefore looking for an opportunity to implement a curve steepener trade in our funds (going short of longer-dated bonds relative to short-dated bonds) when the ultra-low terminal rates narrative gets challenged, but this is unlikely to occur before 2022. In the scenario we have outlined, risk assets would also have a very tough time and we stand ready to exploit any weakness by adding a lot more high yield bond exposure.

If our macroeconomic thesis proves accurate, then we could see a lot of alpha-generation opportunities for our low-beta strategic funds while other investors could suffer from their higher-duration exposure.

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Thursday, November 11, 2021, 1:29 PM