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Viewpoint CIO

At The Top

  • 22 September 2023 (5 min read)

The ‘Table Mountain’ metaphor for the current monetary policy cycle is interesting. Anyone having visited Cape Town might know that you can ascend the mountain via a very smooth cable car ride. The views at the top over Camps Bay and the western Cape are magnificent. The descent by cable car is equally smooth. However, if you make a mistake and miss the last car of the day it becomes a rather treacherous scramble down the escarpment with the light fading and the ‘tablecloth cloud’ flowing over the lip of the mountain. The ‘higher for longer’ approach against a ‘soft landing’ backdrop is the equivalent of getting the cable car back to the bottom of the mountain. But, if central banks get it wrong and the outlook deteriorates, they might have to scramble to get rates down.

Done? 

Phew, that’s another round of central bank meetings out of the way. The US Federal Reserve (Fed) kept rates on hold at 5.25%-5.50%, the Bank of England (BoE) kept rates on hold at 5.25% and the European Central Bank (ECB) raised rates by 25 basis points (bp) to 4.0% but it felt like a ‘on hold’ move. The Fed and the BoE presented their on-hold decisions with a definite hawkish tilt, with the Fed suggesting it has raised its estimate of what the long-run neutral interest rate is and the BoE increasing its balance sheet reduction (i.e., promising to sell more of the UK government bonds – gilts – it owns). There was a surprisingly negative reaction in the markets to what might well be the last moves of the cycle. Yields on US Treasuries rose to 4.5% for the first time since 2007 and gilts jumped around 10bp after the conclusion of the BoE’s monetary policy committee meeting. Central banks will be happy with that; the last thing they want now is the market forcing easier monetary conditions.

New assumptions for rates 

It’s obvious that investors need to factor in a higher interest rate regime than the one that has prevailed for most of the last 20 years. The debate over what is the appropriate neutral interest rate in the US is something of an academic one with the r* rate, as it is known, totally unobservable. But it has practical implications. If central bankers think it is higher now than where it has been over the last 10 years or so this means the current stance of monetary policy might not be as tight as thought. Monetary policy is restrictive – no-one is suggesting the neutral rate is 5.50% - but unless the Fed sees more evidence of the economy slowing and inflation returning to target the outlook for policy is either more tightening or keeping current (tight) conditions in place for an extended period. All the major central banks are suggesting the latter. But the former cannot be ruled out if inflation misbehaves again.

Unusual plateaus

Higher for longer is not a normal situation, however. Since the 1970s there has only been one example of the Fed keeping rates at the peak of the cycle for an extended period. That was in 2006-2007 after the policy rate had been raised from 1.0% in 2003 to 5.25% in early 2006. Rates stayed at 5.25% for 15 months. Normally policy tightening is quickly reversed because normally there is more of a reaction from the economy. I wonder if we might be in more of a 1995-2000 situation. The Fed raised rates from 3.0% in 1994 to a 6.0% peak in 1995. A few adjustments followed until a new peak was reached at 6.5% in 2000, just enough to burst the dot com equity boom. More frequent adjustment to monetary policy with a higher average neutral rate demands a higher term (risk) premium in the yield curve.

The bond story is different now 

The debate is important for bond investors. Active fixed income investors have tried to catch the peak in yields in recent months, looking for lower yields and positive returns from long-duration positions. It has not worked very well, with the over 10-year maturity US government bond index (ICE-Bank of America) having a negative 4.7% return over the last quarter. The equivalent UK gilt index is down 6.5% year-to-date. Increasingly, the market is pricing in ‘higher for longer’ and a higher long-term neutral rate. As I write, the January 2025 Fed Funds Rate is priced at 4.56% with any kind of rate cut not really priced in until the middle of next year. Treasury yields have risen lockstep with the increase in those interest rate expectations. On the one hand higher yields tempt again the long-duration trade, but on the other yields might remain high until the central banks become materially less hawkish.

Equity investors also need to acknowledge the higher for longer regime. Long-term borrowing costs assumptions are integral to equity valuation models – all else being equal higher rates mean a lower discounted value of future earnings. Some businesses will benefit from higher bond yields, other might struggle with a shift in interest expenses. Highly leveraged business with unassuming revenue growth could looks very unappealing from an investment point of view in a prolonged higher rate environment. Multi-asset investors can look at their bond allocations with a view to diversifying equity risk and providing greater opportunities for income than was the case for the last decade. Last year saw everything sell off, but bond bear markets don’t last forever, and higher yields mean more income as a percentage of total return, and the higher yields get, the more income there is.

Beating cash? 

If yields are not coming down much any time soon, what is the view on bonds? It is selectively positive; it must be, given where current yields are. While government (risk-free) yields are lower than prevailing short-term cash rates along the yield curve, investors do have opportunities to lock in yields above cash. Short-duration credit strategies remain a favourite. The yield on the sterling one-to-three year maturity corporate bond index is above 6.0%. High yield bonds are a higher beta alternative with the broad US high yield index offering yields in the 8.5%-9.0% region. At our team’s fixed income forecasting meeting this week the point was made that corporate bonds are not particularly cheap when viewed on a relative value (spread) basis, but the outright yields are very compelling, standing at their highest levels since the global financial crisis and, in many cases, being above levels that preceded that period. 

Positive real returns as inflation falls faster than yields

My hunch is that bonds will provide reasonably positive real returns over the next year with inflation set to fall further. Those returns would be enhanced if expectations that central banks will miss the cable car become stronger. The most recent economic data from Europe – with purchasing manager surveys remaining weak – highlight the softness in some parts of the global economy. However, even with the soft-landing scenario and a stabilisation of interest rate expectations, returns can be positive and credit spreads can enhance those returns. Doing a simple exercise calculating the total return from bonds given a 100bp movement in yields, either up or down, gives a bias towards positive returns on a one-year holding horizon. The level of yield and higher coupons on more recently issued bonds provide a good foundation for income investors.

Changed times

Cash remains hard to beat and cash rates will remain stable at current levels for a while. Betting on lower yields to get the duration kicker to performance has not been successful in recent months but over any meaningful time horizon, the compounding impact of holding bonds with durations longer than three months will eventually deliver returns above cash rates. No-one really liked fixed income when yields were close to zero – the market benefited borrowers rather than investors in the quantitative easing era. Those days are gone. Now we must take care that borrowers have strong enough cash flows and balance sheets to cope with paying higher borrowing costs, but the returns to investors are much more attractive. Bonds are back to stay.  

Root and branch for Red Devils 

I’ve refrained from writing about football for a while. If anyone has witnessed recent Manchester United performances, you will understand why. With only a few games of the season gone, it already looks like a write-off for the red half of Manchester while City might go on to repeat the treble of last year (although hopefully Bayern Munich, Barcelona or Real Madrid will have something to say about that). United’s problems are deep-rooted and unlikely to be solved until the ownership situation is sorted out. Meanwhile, every match is anticipated with great anxiety. If for once the 11 players on the pitch could act like they knew/liked each other, that would be an improvement on recent outings. The beauty of football, however, is that it can always surprise you. I can’t tell you how ready I am for a positive surprise!

Performance data/data sources: Refinitiv Datastream, Bloomberg). Past performance should not be seen as a guide to future returns.

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