Bond Markets Grappling with Reflation Risks

By First Sentier Investors | More Articles by First Sentier Investors

A reflation ‘dance’ between bond markets and central banks will likely continue through the rest of 2021, as the scope and sustainability of the recovery unfolds, according to First Sentier Investors.

In a market update, Tony Togher, Head of Fixed Income, Short Term Investments & Global Credit, said that bond markets are ‘having a moment’.

“Investors are grappling with rising inflation expectations and the idea that central banks will likely let economies run a bit hot before contemplating tightening monetary policy. To throw fuel on the fire, fiscal stimulus around the world continues to flow freely. In the US, the third stimulus package in a year, slated at US$1.9 trillion, is likely to pass through the budget process in coming weeks.”

At the same time, the Australian cash market (AusBond Bank Bill Index) recorded its first ever negative return month in Februaryi – an outcome that Mr Togher’s team had flagged as a possibility in mid-2020ii.

“This was due to the extremely low starting running yield of bank bills of ~1 basis point (per annum), combined with a rise in short-end 3-month bank bill yields, which tripled to 3 basis points at the end of the monthiii. Just like any other debt instrument, when interest rates go down, the price goes up, and when interest rates go up, the price goes down. While the interest rate sensitivity of the Index is very low, because of the construction of the Index it still carries reinvestment risk, as securities are maturing every week for three months.”

By the end of December 2020, Australia had recorded two consecutive quarters of more than 3 per cent economic growthiv, surprising many with its strength. Mr Togher said such momentum creates challenges for central banks.

“If inflation increases meaningfully, there could be increasing pressure on central bank officials to review policy settings. For now, the banks’ commentary suggests that their current accommodative settings will persist for the next two or three years in most of the developed world. Some central banks are even employing yield curve control, targeting specific yields on short-dated government bonds.

“Moreover, expectations of persistently low official interest rates are keeping bond yields artificially low at the front end of the curve. It seems likely we will see some upward pressure on shorter-dated yields over time, but the timing remains unknown.

“Therein lies the problem for investors and asset allocators: while we expect risk-free rates to return to a more normal level, when and how this will happen is not clear. At some point, though, investors will need to recalibrate return expectations for all asset classes and make asset allocation decisions accordingly,” Mr Togher said.

Overall, First Sentier Investors’ Cash and Fixed Income team does not expect inflation to spike sharply.

“While things are developing quickly, in general we believe that the bond market’s recent moves reflect improved fundamentals rather than anything nefarious, or an out-of-control inflation spiral. Longer-term value needs to return to bonds to make them attractive and useful as diversifiers.

“We are actually getting to the point where bond yields are higher than equity market yields in the US, which should boost demand for high quality fixed income at these levels. That said, some distortions are set to remain in the market for a while which makes it a particularly fruitful environment for active managers who can take both long and short positions tactically.”