Volatility in fixed income markets was below 2.5% in 2019, according to the Bloomberg Global Aggregate index, but has risen to above 5% today.
Driving this spike has been a global pandemic, the highest inflation rates in a generation, an unprecedented globally coordinated rate-hiking cycle, a widely expected recession that never materialised, and the return of President Trump – it’s no wonder markets are so volatile.
Amid all this, how can investors capitalise? They need first look to central banks and credit markets.
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At the most recent meetings of the G10 central banks, two have cut rates by 50bps, three have cut by 25bps, four are on hold (of which two are still to embark on the first cut this cycle), and one – the Bank of Japan – is hiking rates.
In credit markets, security selection is becoming increasingly important. In the Euro high-yield market, the amount of notional that is trading at least twice the index-level spread, as well as the amount trading tighter than half the index level spread, remains near historic highs.
The road ahead
Rate markets remain at the epicentre of global market moves, and being able to call the newly inaugurated president’s next policy position is a fund manager’s ultimate ‘Trump’ card.
While the majority of the new administration’s key policies appear inflationary (at least in the short term), time will tell to what degree they are implemented and how the economy reacts. What is clear, however, is that this uncertainty should see the premium for inflation risk remaining elevated.
But even before seeing the impact of government policy implementation, we are observing a US economy with growth marginally above trend and a disinflation process which is stalling at a level above the Fed’s 2% goal as well as a labour market stabilisating after signs of deterioration in the middle of last year, all while interest rates remain above the supposed neutral level.
Given this backdrop, it’s critical to stay cautious and tactical in allocations to US Treasuries. While current macro fundamentals and technicals suggest yields could rise further in the short-term, real yields are historically high and may provide a medium-term opportunity.
In Europe, the picture is quite different, with anaemic growth, slowing inflation, a lack of consensus on fiscal policy and the risk of tariffs having a potentially negative growth impact.
Although sentiment is already negative and a weaker Euro has the potential to stall inflation progress, 10-year German yields have been led higher by their US counterparts and they may present a good medium-term opportunity to add duration.
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We also see potential relative-value opportunities where terminal rate pricing is misaligned, for example, in Norway. Here, disinflation progress has been one of the strongest across the G10 over the past 12 months, yet the central bank is yet to begin its cutting cycle.
In credit markets, it is wise to be strategically defensive given expensive valuations. The additional volatility caused by proposed US government policy, particularly on tariffs, has the potential to act as a catalyst for widening spreads.
However, fundamentals are strong in European investment grade and ‘all in yields’ could still see investor demand, making carry positions worthwhile. We are more cautious on lower quality high-yield bonds and await a higher premium for taking risk in this space.
Elsewhere, forex markets have the potential for a significant regime shift having had limited volatility for some time, especially given the differing paths of monetary policy and the impact potential Trump policies will have.
The directionality of the US dollar is too difficult to call from a strategic time horizon, and therefore nimbleness is critical around positioning. There are also strategic stories including weakness in Sterling and strength in the Yen that are worth considering.
In the UK, economic growth is stalling, the Bank of England may need to cut rates by more than currently priced while fiscal sustainability and a large current account deficit are a concern.
In Japan, still very negative real rates suggest the Bank of Japan should continue to hike rates and see narrowing rates differentials benefit the currency.
And on passive investing, indices focussed on the most indebted countries and companies, with dispersion in credit and fiscal considerations only set to increase further, appears suboptimal.
Once upon a time, fixed income investments may have been considered dull compared to their equity cousins. But today – and for the foreseeable future – bonds are anything but boring.
Jamie Niven is manager of the Candriam Bonds Total Return strategy
This story was written by our sister title, Portfolio Adviser
