The great global bond boom has ended with a bang, after shock US inflation data sent bond yields surging and stocks diving. With central banks in North America and Europe alike signalling an end to quantitative easing (QE), bond investors are suddenly coming to grips with a long-forgotten enemy: inflation.

“It’s definitely a worry--when you are taking this much liquidity out of the market it will inevitably lead to higher volatility, which we haven’t seen for a long time,” says Morningstar’s John Likos, director equity and credit research ANZ.

“These are unchartered waters that we are in, which only serves to increase the uncertainty around this quantitative tightening risk”.

Just how much of a risk was shown on 2 February, when higher-than-expected US wages data sparked fears of inflation in the world’s biggest economy. With wages rising at their fastest pace since mid-2009, bond investors pushed 10-year US Treasury yields to a near four-year high of around 2.8 per cent, causing US stocks to dive along with global equity markets.

On 14 February, keenly anticipated US inflation data showed the headline inflation rate hitting 2.1 per cent in January, above the consensus forecast of 1.9 per cent, although the core gauge stayed steady at 1.8 per cent.

The data pushed the key 10-year Treasury yield towards 2.9 per cent, with analysts suggesting it could reach 3.5 per cent within six months as the market prices in a faster pace of US interest rate hikes. Yields started 2018 at just 2.4 per cent, amid expectations of a measured pace of rate hikes by the US Federal Reserve.

While Morningstar analysts have tipped two increases from the Fed in 2018 of 25 basis points each, the median projection from traders and central bank officials is for three. Four could be possible if the US economic outlook improves further, according to New York Fed President William Dudley.

Other central banks have also joined in a pre-emptive war against inflation. The Bank of Canada recently hiked its official interest rate to 1.25 per cent, while the Bank of England has warned of a rate rise as soon as May. The European Central Bank (ECB) is halving bond buying under its QE program, while the Bank of Japan is widely expected to start normalising policy later this year.

Yet in Australia, Likos sees the Reserve Bank of Australia’s (RBA’s) official cash rate staying flat for the remainder of 2018 at its current record low of 1.5 per cent, and possibly even lower.

“As unlikely as it may seem, the downside remains a very real possibility, given the reluctance of the RBA to increase rates against the backdrop of record high household debt,” Likos says.

Investor impact

For the Australian bond market, rising longer-term bond yields in the United States are likely to influence the longer end of the Australian bond market, according to Likos.

“This could mean bank funding becomes more expensive at the longer end. It could mean potential refinancing risk for weaker issuers that go to the US for their longer duration exposure and longer duration funding,” he says.

For Australia’s home borrowers, the result could be out-of-cycle increases to mortgage rates, even if domestic inflation remains low and the RBA stands pat.

For stock investors, rising bond yields are likely to weigh on “bond proxies” such as real estate investment trusts (REITs) and utilities. In contrast, energy, financial and materials stocks are “positively correlated” with 10-year yields and inflation expectations, and could benefit from a rising interest rate environment, according to RBC Capital Markets.

Likos suggests bond investors consider floating rate notes in an environment of rising interest rates. However, he still expects high-quality Australian issuers to ride out the storm.

“Generally, investment-growth names are pretty well placed and pretty deleveraged…If you look at areas of concern if there’s a property crash, you might be worried about the REITs a little bit. If the ‘Amazon risk’ plays out worse than expected, then we might see more Myer-like scenarios going forward. But generally we see Australian credit well supported on a widening spread,” he says.

Hybrid investors, however, may suffer from a lack of supply, given that banks have less need to raise capital, he says.

“Hybrid investors will be disappointed if they’re after new paper…there will be more hybrids going out of the market than coming in, which will support prices,” Likos says.

“However, we forecast widening hybrid spreads over 2018 due to the higher level of market volatility we’re already seeing offsetting the supply impact."

Asked whether bonds would still be in fashion with investors, Likos says fixed income still had its advantages in capital stability and preservation.

“It just goes back to being realistic with your expectations and not being too greedy, particularly in an environment where there is a lot of fear of missing out, and people chasing higher returns when they often forget the number one thing to worry about, which is capital preservation,” he says.

“Bonds are still as important as ever and there are going to be plenty of outlier opportunities out there for investors”.

 

Anthony Fensom is a contributor to Morningstar Australia

 

© 2018 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 ("ASXO"). The article is current as at date of publication.