Rising rates, markets’ fate – this week from Ash Weston
Apologies – Tom has taken a few well-deserved days off and so you are lumped with me (Ash) again! Before we begin, I will always take this moment to remind everyone that I’m not the analyst or the macro-man, I’m the guy who makes jokes and likes spreadsheets.
That being said, the objective here is to cover the events of last week as it affects your clients’ portfolios, and perhaps the only blessing is the relative simplicity of what I have to cover – the rise of the US 10-year (and global rates more broadly).
I’m going to avoid writing about the evolving Israel/Gaza situation for three reasons;
- The situation is being delivered on a minute-by-minute basis to pretty much every smartphone around the world – you are likely better informed than I.
- The situation (whilst a potential driver of market confidence and sentiment) is changing extremely quickly and the fallout for markets remains to be seen – any comments I’ve read are speculative and clients want certainty. Whilst it invariably increases uncertainty, there are as many arguments that this environment will make it harder for central banks to continue to hold/raise rates.
- Conflicting data and misinformation – trying to find a consensus or balanced view is beyond challenging. The line I’ve delivered to advisers and clients so far is this;Whilst horrific, the market has already borne the fear and uncertainty of these conditions over the last 2 years. Investment Managers are still positioned with the volatility of the Ukrainian conflict within their immediate datasets, and strategies that have worked before should continue to do so. No investment strategy can perfectly navigate a global change in sentiment (see COVID), but investors should remain confident, due to the fact that this awful conflict is occurring within the echo of the ongoing situation in Ukraine.
So, with the focus squarely set on US 10-year yield, let’s begin.
Last Friday, the yield of the YS 10-year broke through 5%. This is important for two primary reasons; it has not done so since spring 2007 AND US debt and US interest rates more generally are the anchor point for (essentially) the rest of the financial world.
I’ll cover this in a way that makes sense to me;
Why has this happened?
How does this effect client portfolios?
Where do rates and markets go from here? (there will be speculation)
…has this happened? The US economy has proven resilient and maintained its GDP growth driven, in large part, by its labour market and a stronger than expected consumer (according to FactSet). Strong growth puts some upward pressure on Treasury yields as they (partly) reflect the growth prospects of an economy over time. Add to this some supply/demand imbalances; essentially demand has slackened, and yields have increased to attract more buyers. Part of this is due to the FED undertaking quantitative tightening and allowing Treasury bonds to roll off its balance sheet, as well as other developed economies increasing their own yields and making them attractive to domestic buyers, as an alternative to US debt.
Commentators are also adding that this yield surge is driven by expectations of central bank rates nearer their peak(s) or that this is simply a reflection of increased issuance of bonds by the US government.
…does this affect your clients? In the very short term, an increase in yields tend to cause stocks to fall as bonds offer greater competition to investors. This period tends to be a “calibration” as the rate changes, essentially as a ripple effect of central bank rate increases. More pressing for the UK portfolio investor is the effect of increasing yields on bond funds, as increased yields devalue the relative value of a bond fund’s existing book of debt (invariably yielding lower) on the secondary market upon which they trade.
The defensive positioning taken by our Investment Team (and to varying degrees) and the rest of the market has been to keep duration exposure shorter over the past couple of years. Duration exists as a function to describe the time risk of maturity of fixed interest instruments. A reduction in duration is essentially a reduction in risk, as shorter duration bond and money market funds aren’t holding books of bonds with 10 or 15+ years maturities that can be devalued in relative terms. Shorter duration funds aren’t immune to rising yields, but the effect is notably lessened.
The flip side of this trade is that when central bank rates DO start to decrease, and shorter-term yields drop, the bond fund managers with maturities that have locked in coupons at a higher rate will be worth more. This dance with bond fund duration risk (relative to the bet of “are we at peak rates”) has been the largest single point of contention and debate amongst portfolio managers these past few months. For the purposes of explanation to clients – it’s not quite parallel with simply “going to cash” before a market crash but is akin to “turning down the volume” on bond fund risk.
…do we go from here? Well, the chart above should give some indication as the 10-year tends to peak around the same time as the Fed funding rate. It’s not really that controversial to state that we are likely near the end of the tightening cycle, although how long and flat the top of the rate “Mountain” will be remains to be seen.
I’ve seen a fair few commentators refer to this as the “new normal” or a “return to normal” if referring to the period before the GFC. Many charts I see only go back 10 years which doesn’t really give a clear impression of what “normal” is. The most sensible people I’ve spoken to think that the 10-year will settle between the 3.5%-4.5% range. Short term, the market can and will overshoot, so expect a bit of volatility but essentially, the official “end of rate increases” should have an immediate cooling effect on yield as investors pile in and try and grab the highest coupons possible.
In the environment that comes after, assuming bonds continue to offer a reasonable return to investors as I’ve suggested, it’s possible that there could be a greater balance between growth and value equity styles vying for investor capital. The low-rate environment post-GFC and pre-COVID really drove investors towards growth equity. In an environment with “normal rates” it could create a much more varied landscape, rewarding active managers that are able to evolve their stock-picking techniques to this new landscape.
Normal service will be resumed next week!
- Ash Weston