There was no mystery surrounding why investors expected the main drivers of financial markets in 2016 to be central bank policy, USD strength, geopolitical issues and China’s economic model reorientation. All of these challenges, and more, were indeed on show during the first half of 2016.
Global growth concerns, driven by China’s slowdown, and an oil supply glut were among the key factors driving down oil prices to unprecedented levels during the early part of this year. This sharp risk-off move rewarded many fixed income investors, especially those with a quality bias, as duration – a key return driver in fixed income investing – performed strongly.
From the beginning of the year to mid-February – coinciding with the drop in oil from $37 to $26 (£20, €23) a barrel – the Barclays US Treasury 20+ Year Index returned 10.51%. Year to date (to June 2016), the Barclays Global Aggregate Bond Index and the Morningstar Global Bond category produced 9.59% and 6.31%, respectively. The clear divergence between the latter two results reflects the continued underweight duration positions being held by the majority of global bond managers.
Record lows
With developed-market government bond yields reaching record lows, the asymmetric risk of the fixed income asset class, especially for sovereign bonds, has become more prominent and supportive of a short-duration stance.
In April 2015, Bill Gross called the German 10-year bund yield at 0.08% “the short of a lifetime”.
Although this was the right call at the time, at the end of June 2016 the same yield dropped to a record low of -0.13%. Given the heightened level of risk aversion introduced by the UK’s EU referendum result, should we expect those yields to go further into negative territory?
According to the IMF, the share of government bonds in the euro area with a zero or negative yield increased from 33% in December 2015 to 43% in February 2016. The story is similar for Japanese 10-year government bond yields, which have been below zero for quite some time, nearing -0.25% at the end of June.
While still positive, the 10-year UK gilt yield fell abruptly from 1.38%, a day before the referendum, to 0.82% at the end of June. US treasury yields have followed a similar, albeit more gradual, trajectory with the 10-year trading at 1.48% at the end of June, after starting the year at above 2%.
Expect delays
Amid the low-growth, low-interest rate environment, central bank policy remains accommodative across developed markets. Despite having witnessed the first rate hike in the US since 2006 – and initially expecting more this year – the continued divergence in central bank policy market participants anticipated in 2016 has not quite played out, even with the US on a hiking path and the UK, eurozone and Japan still operating under loose monetary policy.
At the end of last year, bond markets were pricing four rate hikes by the Federal Reserve in 2016, none of which had taken place as we reached the end of June. The Fed has cited volatility and global growth concerns as the main reasons to moderate the pace and direction of interest rates in the US.
