What's good for bonds
To the relief of many, bond and currency markets have been exhibiting significantly lower volatility over recent weeks. “At the moment, global risk has quietened down and it is relatively calm,” agrees Keith Kelsall fixed income strategist at Barclays Global Investors (BGI). “Rate rise expectations are already priced in to yield curves in the both the US and the UK. With US inflation running higher than the 1% Federal Funds rate, that’s a negative real interest rate. It is quite clear that the Federal Reserve (FR) definitely needs to hike. It is highly likely that the Fed is behind the curve – the market is clearly factoring in more inflation as breakeven inflation spreads on TIPS have been widening,” he says.
While rising inflation is obviously a tricky issue for fixed income investing per se, for Roland Lescure at CDC Ixis Asset Management its return is to be welcomed, not reviled. “Yes, it is a good thing. We are coming from such a low level of around 1% that a steady increase over the next 18 to 24 months to say the 2.5-3% level, ought to be viewed as part of the economic reflation which is quite OK. What would matter
is increased labour market/wage inflation, that would be bad for bonds.”
Both Lescure and Kelsall agree that it is unlikely that inflation will become the dreaded issue, for bond markets especially. “For the past year we have seen strong global growth, in fact we haven’t seen such a strong cyclical upturn even in Europe, for decades,” says Lescure.
“Because the depth and extent of the recession was unheard of, so the recovery is turning out to be prolonged too. I believe that there have been two supports to this recovery. Initially we had the massive budgetary and monetary reflations – I call this the ‘artificial’ driver – which cannot go on forever and we are already seeing their unwinding. And the ‘real’ driver is now to reap the benefits of corporate restructuring processes. Those massive imbalances from 1999 through to 2002 have been unwound and we see corporate America, Europe and now Japan have healthy balance sheets. This is a healthy situation to be in and one where we do not need to worry unduly about inflation.”
Kelsall continues in a similar vein: “Inflation is genuinely not coming back. Yes, we have had a particularly strong recovery in the US, but we also have very, very tough corporate competition, and after all the restructuring there is no wage pressure. There is now less ability for employees to negotiate high wage increases with the upper hand in negotiations still lying with employers – restructuring led to less stable employment and a greater pool of available employees.”
Lescure thinks that the European Central Bank (ECB) should also be reassured and that EU inflation is only just above target. He suggests that the current high oil price is not delivering an inflationary shock but it is actually reflationary. Of course he adds, that further oil price rises would be dangerous and that the impact would be bad news for markets. But he says that most of the rise in the oil price is linked with the dynamism in global demand, and should be seen as a sign of strength rather than a sign of weakness.
BGI’s Kelsall suggests that the ECB would not be willing to turn a blind eye to higher inflation of any sort. “The Central Bank has a strict mandate to control inflation and I do not believe they would find any reason not to act to fulfil that mandate. There are worries for them in the form of the oil price and currency volatility.
There is now little doubt that there will not be further cuts, but there is also no pressure in general to increase rates in the near future. With unemployment over 10% in Germany and about that in France too, it would be awkward to raise rates. On the plus side, however we know there is lots of spare capacity across Europe and the ECB would certainly have no need to act before the US.”
For many investors the oil price is perhaps the most worrying issue. The debate over just why oil has reached about US$40 (e33) per barrel goes on. Opinion is divided between those who argue that it’s because of excessive demand from China and the US and perhaps the rest of the world as economic recoveries gather pace, and others who point accusingly at ‘evil’ speculators. Who or whatever is to blame, as Kelsall states: “Oil is the biggest unknown over the next six to 12 months and is a very significant factor for all markets.”
Morgan Stanley has recently been running some oil price scenario analyses. Their work suggests that at $80 per barrel of oil there will be aggregate inflation but that the relationship between oil and general inflation experienced in two previous oil shock years 1974 and 1980 will be less pronounced this time.
Kelsall, who tends to agree with this analysis, says: “I believe that an oil shock is fairly unlikely unless there is a major disaster in the Middle East. Even if the oil price were to spike up to very high levels, outside of the US this would probably not have as great an effect as in the 1970’s due to the amount of oil reserves that the US holds for just such an eventuality.
“Outside the US, consumers would not feel the effect quite so harshly due to the already high taxes on fuel cushioning the actual percentage increase they would experience. Nevertheless, this would obviously put upward pressure on inflation and would be negative for bond markets. On the other hand it would almost certainly disrupt global growth, meaning that rises in bond yields would most likely be tempered by concerns that the global economy would not continue to grow at its recent pace.”