Bonds get riskier
Stuart Dear says that central banks now accept that their loose monetary policies have side effects.
There was some sense in markets that September marked the beginning of the end. September’s focus was on whether the Bank of Japan would step away from quantitative easing following its review of policy, and there was additional chatter that the European Central Bank was considering ‘tapering’ its purchase program. In the event, no material changes to the programs were announced and, with the Federal Reserve again sitting pat, global policy held steady, as did the markets despite a wobble early in the month.
It was, however, a month in which it appeared that central bankers were at last hearing the concerns about their current approach. The two major concerns are around extreme monetary policy’s 1) effectiveness, as lowering the price of money has not been a good signal to the real economy though clearly it has been a boon to the financial markets, and 2) side-effects, including inequality and instability of the financial system (as low rates alongside increased regulation have crimped bank profits). We’ve had prior episodes of restlessness around the current path of monetary policy – for example, in January this year, when the concern was that monetary policymakers were ‘out of bullets’ with cash rates and bond yields at/through zero and bond scarcity problems arising. But each time central bankers have responded by either increasing the size of the program, or tweaking its implementation.
One month is not enough time to draw any strong conclusions. To say this is the end of monetary easing would be to jump the gun massively. The ECB, BoJ and the Bank of England are engaged in big purchase programs – worth $250 billion per month – that are expanding the collective central bank balance sheet and are more than absorbing net bond supply. Even with a diminished pace of purchases, central banks will be buying bonds for a considerable time to come. Central-bank credibility and financial-market dependence call for a careful retreat when it eventually comes. The September news really was not that central bankers are about to give up on quantitative easing, but that they realise – for example in the way the BoJ is starting to experiment with yield rather than volume targets – that the days of one-way policy direction are numbered.
Marginal change matters for markets. We have long argued that central bank policies are being too aggressively pursued in the face of reasonably benign economic outcomes, and that their application has distorted prices of all financial assets, especially government bonds. While we are wary of calling an end to the bull market in bonds just yet, a marginal step away from quantitative easing is likely to be significant.
Even without a big selloff in bonds, the return-versus-risk trade-off for fixed income is changing at low levels of yields. Both the starting point for returns (ie current yield) is lower, and return distributions are more negatively skewed (as upside is limited by the extent to which yields can trade down through zero). Given bonds have been the traditional defensive asset, these changes carry implications for the way fixed-income portfolios as standalone portfolios, and broader portfolios in which fixed income is a component, are managed. We are probably entering the most challenging time in living memory for bond investors. In our eyes, active management remains essential, and a valuation-driven approach becomes even more important.
The tension between absolute and relative outcomes has rarely been more obvious than the last few years. Throughout we’ve been aiming to protect portfolios from the risk of capital loss that extended valuations entail, largely by running shorter than benchmark duration positioning, and while absolute returns have still been respectable this has seen us underperform the benchmark. Our portfolio risk, measured both in traditional volatility terms, as well as in terms of risk of drawdown, has been considerably lower, such that portfolio and benchmark risk-adjusted returns have been about equivalent. In light of the above, our portfolio remains cautiously positioned.
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