Unsettled bond markets… Here to stay?

Recent moves in the bond markets have unsettled investors used to low yields. Aubrey discusses his take on what lies ahead for bond buyers and how to best navigate the changing environment.

Global reflation is gaining traction. Central banks are hiking rates. The world has changed, and that has unsettled bond markets used to low yields/rising prices throughout the post-recession expansion. What lies ahead? We believe pretty much the same, only more of it.

iSH Blog Yield Mar18.1

In the U.S. we expect a continued pattern of broad rallies and selloffs, conditioned by macro and technical factors as the Federal Reserve (Fed) calibrates toward a neutral overnight rate. Rates would likely rise if inflation ends up sticking above the Fed’s implied two-percent target, spurred by higher wages and protectionist trade policies. Moreover, money for fiscal stimulus may translate into net Treasury issuance this year of US$1.3 trillion at a time when the Fed itself is no longer a buyer.

On the other hand, relative valuations are attractive: 10-year U.S. Treasuries now yield about 150 bps more than the average among G-7 peers1. Meanwhile, along with higher discount rates, we’re seeing higher volatility in risk assets. That should cause risk assets to re-price lower and encourage capital flows to fixed income.

For Canadian bonds, we expect a similar wavelike pattern as for U.S. Treasuries, but with a higher frequency, driven by factors that will alternate between local macro considerations and the pull from how U.S. interest rates evolve. In the near term, we see a market at an inflection point, where interest rates have topped out on a short-term basis.

Our view is that we are still living in a low-yield world, though the trend is clearly toward higher rates. Tactically, now may be an appropriate time to consider taking on more interest rate risk; nominal yields on government bonds look attractive and we believe can persist through the quarter. We would also be wary of the richness in risk asset pricing as volatility picks up. Investment grade, high yield and emerging market spreads are currently trading relatively rich. To be clear, we are not predicting a downturn: the expansion still has room to run. Yet reaching for some relative safety makes sense, given current conditions.

Strategically, we continue to believe active management better positions investors in this kind of environment. Heightened volatility can present opportunities for both offense and defense. Get ready to look for them!

1 Bloomberg: As of 02/28/2018

Aubrey Basdeo is a Managing Director and Head of Canadian Fixed INcome for BlackRock. He is a regular contributor to The Blog in Canada.

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