Turmoil across the banking sector, sparked by the collapse of Silicon Valley Bank, has ignited fresh doubts among investors over the outlook for interest rates and bond yields — at a time when inflationary pressures globally remain uncomfortably high.
Central banks on both sides of the Atlantic have repeatedly emphasised their determination to bring runaway inflation under control. But additional hikes in interest rates could create more instability across the banking sector and increase the risk of pushing economies into recession.
At the start of April, financial markets were pricing in a 50 per cent chance of a 25 basis point increase in US rates in May, followed by a decline to around 3 per cent by the end of next year.
However, Jim Cielinski, global head of fixed income at asset manager Janus Henderson, expects the Federal Reserve to hold rates at their peak level for longer than the market is currently factoring in, because of policymakers’ failure to achieve their main task: ensuring price stability.
“The notion that US rates can be cut at the first sign of trouble, and that central banks will do more quantitative easing if conditions get tough . . . that era is over,” says Cielinski.
He believes that headline US inflation has passed its peak but will remain structurally higher — and is unlikely to return to the target levels set by the Fed. That leaves investors having to contend with higher inflation risks, greater geopolitical risks, and more uncertainty about the path of monetary policy.
“The front end of the yield curve in most sovereign bond markets provides the most attractive risk-reward balance,” Cielinski says. “The US yield curve is steeply inverted and it is not clear why an investor that is worried about inflation would prefer a 10-year Treasury bond over two- to five-year Treasuries.”
Stephen Jones, chief investment officer for fixed income at Aegon Asset Management, is also concerned that investors are overconfident about inflation returning to very low levels. Aegon is recommending that clients stick with less-risky fixed-income assets, including short-term government and investment-grade bonds.
“Investors can consider adding duration — fixed-income assets that are more sensitive to changes in interest rates — later in the year when the outlook for monetary policy becomes clearer,” suggests Jones.
Uncertainty about the outlook for inflation and interest rates, combined with the danger of problems spreading across the banking sector, has increased volatility in the bond market.
The Ice BofA Move index — a measure of bond market volatility — has risen to levels last seen when Lehman Brother imploded in 2008.
Fraser Lundie, head of fixed income, public markets at Federated Hermes, says that central banks will try to “hold the line” on interest rate policy but disruptive events could become more frequent.
“Policymakers will be aware that things are already breaking due to the tightening of monetary policy, with the difficulties in the US banking sector following only a few months after liquidity problems among UK pension funds triggered a crisis in the gilt market,” he points out.
Federated Hermes says that US and European investment-grade bonds and convertibles are looking more attractive as a result of the pricing shifts that occurred during the banking crisis in March. It is more cautiously positioned in lower-quality high-yield bonds where smaller issuers and private companies have fewer levers to pull if the underlying business encounters problems.
Henrietta Pacquement, head of the global fixed-income team at the US manager Allspring, says that it is “not a surprise” that signs of stress are starting to emerge, given the speed of interest rate hikes over the past 12 months.
“Companies are having to contend with increasing costs and rising wages so we have passed the peak for financial health for the corporate sector,” says Pacquement.
Investment grade bonds still look attractive to Allspring in this “less forgiving economic environment” and the manager also expects opportunities to open up in the high-yielding parts of fixed income later this year, when valuations catch up with the deterioration in corporate fundamentals.
Looking further ahead to next year, Steve Ellis, global CIO for fixed income at Fidelity International, thinks the threat of a credit crunch for US companies — due to problems in the bank sector and the growing risk of a hard landing for the American economy — could force the Fed to cut its main policy rate sharply.
Adding “duration” — exposure to bonds that are more sensitive to changes in interest rates — in US investment grade credit may be an attractive option at this stage in the cycle given its defensive risk exposure to any hard landing.
“Investors should want to take more interest rate risk as the Fed is already providing additional liquidity and likely to loosen monetary policy later this year,” says Ellis.
Ten-year US inflation-linked bonds are offering 1.28 per cent a year above US consumer price inflation — which provides an attractive way to take out some inflation protection, according to Fidelity. But the asset manager is still cautious about the US junk bond market, where the average yield of around 8.2 per cent is still implying a very low level of defaults — around 3 per cent — this year.
“It is not obviously clear that pricing in US high-yield bonds is offering enough protection, given that the US economy is facing a credit crunch and a hard landing,” warns Ellis.