The low-for-long era is over.
Central banks, fiscal activism and populism pricked the bond bubble in 2016. Next year will be a lot worse for bond investors, and the aftershocks of the burst will spread across many other assets.
Since the crisis, investors have been buying bonds for capital gains and equities for yield, trusting in the holding hand of easy monetary policy. However, today the central bankers’ hand is no longer there.
This summer, the BoJ and then the ECB both changed their mantra from whatever it takes to less is more; targeting steeper yield curves and the transmission mechanism of stimulus to the real economy, moving away from unlimited asset purchases.
They are right in doing so. The economic equilibrium that quantitative easing (QE) created was always an unsustainable one. Monetary stimulus without appropriate fiscal action encouraged misallocation of resources to zombie firms and banks that should otherwise restructure; created asset bubbles in high dividend equities, property and precious metals, as well as art and collectibles; and widened the gap in relative wealth between the haves and the have-nots.
There are few places to hide for bond investors in this environment. Even as QE infinity fades, the rise in inequality continues to provide fertile ground for politics of rage.
Brexit, Trump and the recent No vote in Italy’s constitutional referendum may all lead to wider deficits, less structural reform and protectionist measures such as tariffs on international trade or limits to migration.
Fading monetary policy and fiscal activism are bad news for bonds, pushing yields and inflation higher.
Ten-year inflation expectations have risen to 2.3 per cent in the US, over 3.5 per cent in the UK and 1.4 per cent in the eurozone over the past six months. Protectionism is bad for bonds and growth, too: trade tariffs and limits to the movement of workers generate inflation without addressing any structural economic shortcomings.
The Federal Reserve is already changing tack to respond to fiscal stimulus and higher inflation. With or without a new chair, the Fed’s hike path is likely to be faster, as political debate shifts to more control over monetary policy, prioritising rule-based inflation targeting over full employment.
Unlike recent crises, emerging market debt won’t provide much of a refuge this time around
In the eurozone, where bond markets price a goldilocks scenario and core mid-maturity bonds still yield negative, this means that investors could be hit by a triple-whammy: a less dovish Fed and a stronger dollar will boost exports and inflation globally.
Germany, the most sensitive economy to a depreciation in the euro, will overheat and will probably increase pressure on the ECB to taper, while France, the Netherlands and Italy may see a further rise in protest votes at upcoming elections.
This creates a lose-lose outcome for bonds: pressure for the ECB to taper in a good growth scenario, versus wider semi-core and periphery spreads if growth is weak and populist parties win.
Unlike recent crises, emerging market debt will not provide much of a refuge this time round. We estimate that China’s reserves, together with its capacity to raise more public debt, are just enough to absorb losses from bad bank loans and restructure its state-owned companies.
However, eventually a sharper depreciation in the renminbi could be necessary, which would drag down other EM currencies with it. Having increased hard currency debt since the crisis because of low rates, many EM borrowers are vulnerable to a mismatch in liabilities against their local currency revenues.
The biggest losers from the end of low for long next year are all the assets that investors only bought for yield: passive and long-only strategies in government and investment grade debt, including corporate bonds trading at record-low spreads because of the ECB and BoE’s purchase programmes, but also utility and telecom stocks, so-called low-volatility funds, and Reits.
Who are the winners? Those assets that everyone shunned since the crisis because of low rates and deflation fears: Japanese equities, cyclical sectors such as industrials and construction but also banks and insurers, inflation-linked debt, energy commodities and metals; as well as those strategies that underperformed against a market guided only by central bank signals — for which you did not need a fund manager.
The rotation out of coupon-generating assets has already started. Yet bond investors’ duration exposure remains high, at 6.8 years on average in October, according to IMF data.
That is up from five years in 2008. With rates and risk premiums at record lows and barely compensating for inflation, there is probably more pain to come for fixed-income investors before the grand finale.
Alberto Gallo is partner at Algebris Investments and manager of the Algebris Macro Credit fund