Crystal Wealth Newsroom
Bond rate rises and long-term strategy matters
The recent rise in long-term bond rates has focused the market again on relative valuations and increased trading volatility, and raised the question of where to next? Short-term noise aside, it’s important to understand what this means for current portfolio positioning.
It’s to be expected that bond yields will rise when you have economic recovery, and it’s not necessarily a problem for markets provided it’s orderly and matched by an increase in underlying earnings and profit expectations. The key here is the pace of change. The market hates sharp, rapid rises as it makes subsequent asset price changes hard to adjust in a timely way.
At present, what we’re seeing is the debate between market expectations and the Central Bank’s policy to anchor rates still for another two to three years. Keeping rates low is understandable if we don’t experience persistent inflation, but what happens when we do? The market doesn’t necessarily think Central Banks can hold cash rates as low as they are for that period of time, so interest rate expectations start to shift. Higher inflation, leading to higher rates means the yield curve starts to move, which means an expected rise in implied future interest rates appearing in higher long-term rates. Hence the shift up of around 1% p.a. in the 10 year US treasury and Australian Government bond rates over the last couple of months.
With the COVID-19 tracking data suggesting we are past the peak of the pandemic, we enter the recovery stage of the business cycle. Unlike other recessions, this is one in which the consumer has probably never been in a stronger position from which to emerge, primarily thanks to the government support measures that have been in place for the past 12 months.
The big unknown at present is what happens when the government handouts stop. Many people have been able to save and even pay off more of their mortgage, but will they need to draw down some of their equity again once the Jobkeeper payments stop and Jobseeker reduces? How will businesses – and hence employment levels – be affected without ongoing government support? This is still a big unknown.
The pathway isn’t clear and it depends on a number of key variables, including virus mutations, the need for further lockdowns, our rate of vaccination and pace of reopening of borders, as well as ongoing fiscal and monetary policy support. For example, as government and corporate debt levels remain high, economies will be sensitive to borrowing costs and any rise in real interest rates (i.e. after inflation). This goes to the heart of recent market moves and rotation between different stocks.
So, when you put all of that together, it’s no surprise to see some increase in long-term bond yields. After all, this should be a positive sign of future economic growth expectations.
The impact of interest rates
Remember, despite all the talk of rising rates we still have negative real interest rates.
While headline 10 year interest rates may be around 1.6-1.8%, we’re still targeting inflation to be in excess of 2% (this means real rates less than zero). So, what we’re seeing is some volatility coming through: if bond yields increase further and inflation expectations don’t change that effectively increases the real interest rate. If the real interest rate increases, it’s a negative in particular for the sectors that are exposed to longer-term discount rates, such as high growth technology and communications and consumer discretionary stocks. Globally, the US market benefited the most as real rates fell, given its growth focus, which also makes it sensitive to any rise back the other way.
Some of these growth sectors (as illustrated within the Nasdaq technology index) have sold off from their previous highs and there’s been a rotation into other areas that are perceived to be more cyclical and exposed to future economic growth, such as resources (commodities and materials), energy, travel and tourism and financials.
Because of this continued debate, we expect short-term trading volatility to remain between different sectors of the market (as inflation and real yields vary), so it’s important to take a step back and view things in context.
We expect rates to rise – they have done quite a bit already and there could be more – but we’re not talking about an environment where inflation is getting out of control and hence interest rates need to rise quicker than currently expected. In fact, our own Reserve Bank was quite explicit in stating that it wants to see the output gap close and real wage price inflation emerge before targeting the cash rate. The level of spare capacity in the labour market is a key indicator to watch here.
We’re going to see spikes in inflation, in GDP numbers and hence probably bond yields, as the headline numbers will be based off a low base year (2020) – this is natural. The question is whether this is something that can be absorbed within current policy settings.
High single figure and even double figure interest rates will be something those of us who had mortgages in the 1970s, 80s and 90s will remember only too well, but it’s not a prospect that’s on the horizon today. Given the existing stock of debt, Central Banks would only have to increase cash rates 2%-3% to severely hit the brakes on any economic recovery and possibly send it in reverse.
Keeping the long-term investment strategy in mind
Regardless of any short-term volatility, it’s important to be mindful of the long-term investment goals while looking for opportunities that emerge in this changing environment. It also means, on balance, investing in an environment where growth or risk assets still offer a premium over defensive, lower yielding assets – just with more risk.
There are long-term structural shifts evolving across the world, such as the transitioning from a carbon-based economy to a greener, more sustainable economy, the expansion of cloud-based services, the move to ecommerce and contactless payments, the advent of 5G that will continue irrespective of the current rates debate – and there may also be some short-term trends as economies start to recover (e.g. infrastructure spending, travel, commodities).
We need to be mindful of where we sit on this spectrum, and not just chase rotation trades – for example, it doesn’t mean a quality long-term growth company should be ditched now because there might be a rise in inflation and interest rate expectations.
We want some exposure, no question to the ‘reflation trade’, but we still need balance. And there are plenty of risks that need to be hedged against. You still need to be suitably diversified. This includes within sectors and across countries. Different countries are clearly at different stages of the ‘recovery’ and COVID management and hence will respond at different rates.
Ultimately, it’s important to remain mindful of the environment that you’re in and also pay attention to your risk profile. Future return expectations have been lowered across the board in every asset class.
So you need to keep working within your framework and comfort zone, not just chase returns at any cost. If you want to change your risk profile, that’s a different story of course, but it’s not an environment that dictates just buying more risky assets. In fact it can be disastrous if you can’t ride out the inevitable downside moments as well with a higher risk profile. The good news is at least inflation remains low and this is one to watch moving forward.
If you’d like to discuss your investment strategy, talk to your adviser or the team here at Crystal Wealth.