Will the COVID vaccine kill the bond market?
Central banks will take a cautious approach to tightening and so should investors in their search for yield, writes Anthony Fensom.
The COVID-19 vaccine’s global rollout has coincided with rising bond yields, as investors anticipate higher inflation on the back of the expected post-pandemic recovery. Should fixed-income investors be worried?
Morningstar’s head of equities research, Peter Warnes, states that “low bond yields have provided an abundant supply of oxygen to risk asset valuations for several years … While investors have been rewarded by believing central banks and governments will support the economy no matter what, that support is unlikely to remain in place in perpetuity.”
Yet despite central banks’ massive monetary stimulus, long-term bond yields have recently hit their highest levels in nearly a year.
Australia’s benchmark 10-year bond yield has reached 1.4 per cent, up 43 basis points from year-end, while the US variant has also climbed by 37 basis points to 1.28 per cent, Warnes notes.
“The yield curve continues to steepen, signalling accelerating economic growth and/or inflationary pressures,” Warnes said in the 18 February Your Money Weekly newsletter.
Evidence that inflation might be returning came from January’s US producer price index, which jumped by 1.3 per cent against expectations of a 0.4 per cent rise—“the largest monthly increase since the index underwent an overhaul in 2009.”
Westpac chief economist Bill Evans expects the US 10-year bond yield to reach 1.8 per cent by year-end, climbing to 2.4 per cent in 2022 on the back of accelerating global growth.
In Australia, inflation bounced back in the December quarter, with the consumer price index rising by 0.9 per cent, led by alcohol and tobacco and childcare. However, “underlying” inflation was just 1.3 per cent, well within the Reserve Bank of Australia’s (RBA’s) 2 to 3 per cent target band.
MORE ON THIS TOPIC: Australian Credit Monthly
RBA: No change until 2024
At its latest policy meeting on 2 February, the RBA maintained its 0.1 per cent target for its key cash rate and the three-year government bond yield, as well as adding another $100 billion in bond purchases.
The decision came amid “subdued” wage and price pressures, with both expected to remain below 2 per cent “over the next couple of years.”
The RBA said it would not increase interest rates until actual inflation is “sustainably within the 2 to 3 per cent target range. For this to occur, wages growth will have to be materially higher than it is currently … [requiring] significant gains in employment and a return to a tight labour market. The [RBA] does not expect these conditions to be met until 2024 at the earliest.”
Australia’s central bank has argued that its bond-buying has helped reduce the long-term government bond yield by about 30 basis points, as well as lowering the exchange rate. It also says the nation’s post-pandemic recovery remains dependent on the public health situation and on “significant fiscal and monetary support.”
Capital Economics expects the RBA to extend its quantitative easing (QE) program by another $100 billion, “perhaps in June,” with any further extension dependent partly on the actions of other central banks.
The London-based consultancy expects the RBA to cease further bond purchases at the end of August. It expects yields of 10-year developed market government bonds will not rise substantially until the end of 2022, with the US Federal Reserve unlikely to hike rates until 2024.
“In our view, major central banks will generally take a more cautious approach to tightening monetary policy than they did in the past. This underpins our forecast that the yields of 10-year government bonds in both developed and most emerging countries will generally remain below their pre-COVID-19 levels even as the global economy continues to recover over the next couple of years,” Capital Economics said in a 5 February report.
The latest minutes of the Fed’s policymaking committee stated it would continue accommodative policy until its employment and inflation targets (2 per cent over the longer run) had been met. Most economists do not expect any reduction in its QE program until 2022, according to a Bloomberg survey.
Stick to quality
With easy money seemingly set to continue for longer both in Australia and the US, how should bond investors react?
“The base case in the market currently is there will be an economic recovery in the second half of this year, as the [COVID-19] vaccine is rolled out. There will be some inflationary pressures and bond yields might start slowly creeping up, but I don’t think central banks will allow them to spike too fast, too soon and damage the recovery,” said John Likos, director, investment management at BondAdviser.
“All of those elements promote a risk-on environment, so investors will likely increase their equity allocations and go further down the capital structure in credit seeking higher-yielding opportunities,” he added.
However, Likos cautions against straying too far from quality issues in the search for yield.
“With benchmark rates still extremely low, we couldn’t caution more that you shouldn’t be chasing the higher risk issues. Make sure you’re invested with strong credits and reputable fund managers, not fly-by-night operators or highly leveraged issuers,” he said.
“While we don’t have any issue going down the capital structure in 2021, we’re doing it with the stronger issuers like the banks and telecommunications companies—investment-grade options. The message has never been more important to not chase yield beyond your risk tolerance this year.”