Prepare your portfolio for rough times ahead.
Recent volatility in global bond markets and government yields could be just getting started. If that’s the case, investors might want to prepare for potential buying opportunities in the bond market if they have dry powder available.
The bond market is throwing another tantrum amid fresh uncertainty surrounding central bank policies. Investing in bonds with low and negative yields requires confidence and certainty, both of which have been suddenly eroded.
The resulting volatility and jump in government bond yields have been a splash of cold water to the face of investors who have grown complacent over the “lower-for-longer” mindset. Looking ahead, there are several reasons why global bond markets could remain unsettled, apart from the U.S. presidential election. Although investors are focused on the possibility of Federal Reserve interest-rate hikes, the recent volatility has also been driven by comments from other central banks.
First, the Bank of Japan is reportedly exploring ways to steepen the yield curve in Japanese bonds to help the banking sector and, therefore, aid its transmission method for policy. The BOJ has also promised a broad review of its policies at its upcoming meeting. Meanwhile, European Central Bank President Mario Draghi last week declined to comment on whether the ECB would expand its bond-buying program, and again called on eurozone governments to help with fiscal stimulus. Also last week, Federal Reserve Bank of Boston President Eric Rosengren said there is a reasonable case for the Fed to gradually raise rates.
Put it all together and we’re potentially seeing a change in tone from central banks on interest rates and the slope of global yield curves. The ECB and BOJ have acknowledged publicly that the compression in yield spreads from short to longer maturities has hurt bank profitability. The implication is that with profitability hindered, banks have less incentive to lend.
If the ECB and BOJ do adjust policy to support banks, this could open the door to Fed rate increases marginally. The Fed has been boxed in by inflation and unemployment targets that have largely been achieved, and the fear of dollar strength. However, the ECB and BOJ could be providing tacit approval for the Fed to hike with less fear of currency strength. The long end of global yield curves could see upward pressure based on this adjustment, as well as fiscal policy crowding out what would normally be private borrowers.
Low rates and the hunt for yield have driven feverish buying of dividend income, an acceptance of duration and potentially excess credit risk, as well as leverage. These are all potential pain points if unwound, and longstanding carry and momentum trades could be impacted.
By Kathleen C. Gaffney, Co-Director of Diversified Fixed Income and Henry Peabody, Diversified Fixed Income Portfolio Manager/Team Leader