Are we nearly there yet? Bonds and the end of 2021
We recently added back some duration to our portfolios. As we head into the end of the year, we see a few dynamics that we believe are skewed towards lower yields (globally, not just in the UK) – but not ones strong enough to make us want to move materially away from the current very low duration position we hold in our absolute-return mandates.
So what are these dynamics going into the yearend that would generally imply lower yields?
There is a widely held assumption that the link between cases and hospitalisations is broken and that there won’t be any need for further economically damaging lockdowns. We aren’t expecting such new restrictions, but we believe the risk is one sided.
The labour market
Before the end of the year, we will only have two more US labour-market data points. The Federal Reserve is beginning to believe that not all of the pre-COVID workforce will return, meaning that the labour market will be tight (and the central bank can hike rates) before the total number of employees reaches pre-COVID levels. The next two data points are probably not enough to give them certainty that this is true, but either of these data points has the potential to disprove it.
Market participants all seem, in a very short space of time, to have pushed out their best guess at when supply disruptions ease. A widespread consensus has developed that supply-induced inflationary pressure will be with us for at least the next six months. As firms adapt to new realities, expectations can be pulled back as quickly as they were pushed out.
Policymakers in China have continued to tighten credit conditions in the all-important property sector. Because bottlenecks have kept headline inflation high, the weakness in Chinese domestic demand hasn’t found its way into narratives about global inflationary pressure, but this remains a substantial risk – particularly if the current bottleneck consensus unravels.
The Federal Reserve
The Federal Open Market Committee (FOMC) – still the world’s most important central bank – is currently pushing on with tapering. We do not believe they will want to rock the boat by lurching straight from taper talk to discussing imminent policy rate hikes. And we believe they will not want to stir markets around Christmas (particularly given the disaster of 2018). It will therefore be hard to see much change in FOMC views before 2022. The one tricky point in the calendar for the FOMC is on 15 December, when they have to release a new set of interest-rate forecasts.
Duration has two roles in the portfolio: as a source of potential returns, and to seek to offer protection to the portfolio against deflationary macroeconomic shocks (like recessions). Let’s take each in turn.
Source of returns
Over the next six months, we don’t have a strong view about which way yields move. We see compelling arguments in both directions, and think we are best waiting for more information before lurching one way or another. In my next blog, I’ll discuss some of the key questions we’re asking.
Source of protection against deflationary macroeconomic shocks
We believe there are better alternatives. In particular, we prefer selling long-dated inflation (think selling inflation for 2027-2032), mainly in the USD markets, to owning duration. I’ll explore this more in my next blog.