The European Central Bank appears to have mostly got its way with the Germans.
Quantitative easing is finally happening in Europe. Markets are cheering and the euro is at an 11-year low against the dollar.
Are we likely to see a renewed ‘put’ on asset price support and volatility staying low – setting off the whole chase for yield once again?
It would seem so. In the past five years the other leading central banks have expanded balance sheets by about US$10 trillion. Stock and bond markets have soared.
But if the primary intention of policymakers was to promote growth and prevent disinflation rather than to boost asset prices, spending has failed. Growth has stayed fitful in all the major countries.
That said, at some point, probably mid this year, it was assumed that the US would achieve some kind of escape velocity and that would allow the Federal Reserve to raise interest rates – for the first time since 2008.
No one promises this transition to be smooth, but the exit risks – chiefly of higher borrowing costs hurting borrowers in a debt-strained world – have seemed manageable, provided the Federal Reserve remains alert.
Until now. We increasingly suspect this ‘normalisation’ is not just delayed but being challenged. Far from seeing longer-dated Treasury yields rise, spreads have compressed and volatility is evident along the curve.
The reason for this is fear of deflation as well as the actions from central banks such as the ECB to combat this.
At the zero-bound interest rate level monetary policy struggles to be effective. Demand stalls, investment shrivels and debts become more onerous.
Cash under the mattress
In Europe interest rates are negative in a handful of countries, which is akin to saying investors are better off leaving money under the mattress – and thus the financial system is no longer working. In short, the problem is structural.
Of course, the US does seem to be in a better situation than Europe. We sense growth is finally improving. If signs did emerge that falling unemployment was leading to wage growth, then this could put renewed upward pressure on US Treasury yields that we were expecting all along.
Still, the point for now is that volatility has increased because of these wider potential outcomes. And Federal Reserve chair Yellen would rather be slow in raising interest rates than wrong on deflation.
With those caveats in mind, we see three main developments fixed income investors can take advantage of.
First, interest and growth rate expectations will continue to support US dollar flows. Aggressive intervention by Japan and the EU to weaken currencies and boost competitiveness exaggerate the trend. The euro could hit parity with the US dollar.
Second, the downside of US dollar strength is the reduced capital available in emerging markets. Asian currencies as a basket will struggle. But unlike in previous cycles policy makers have more flexibility to act.
For example, the Indian rupee is firmer because it is less correlated to global currencies and domestic reforms are progressing convincingly amid a slowdown in inflation.
That has raised hopes of further interest rate cuts after a surprise move in January.
Other countries are not so lucky because policy credibility is lacking, foreigners own a large slug of local debt and trade balances have been deteriorating. For Australia at least, RBA policy credibility is not an issue.
Thus the opportunity is to find the pockets of value available in these diverse markets, not just in terms of countries but also sectors and individual securities.
Taking credit
Nowhere will focus be more necessary than in credit, where central bank bond buying had been back-stopping the ‘search for income’.
Stress is building among oil and energy corporate borrowers because of the collapse in crude prices. The risks of a ‘Grexit’ add to investor caution. Australia has its own resources-related slowdown to contend with.
So our third thought is that the days of chasing extra returns without regard to risk have passed.
Should those risks ripple out, a lack of liquidity from fewer market makers and shrinking US dollar flows could worsen matters for issuers in Asia-Pacific.
An outright collapse in high yield markets is not our core scenario. Even so, differentiation within credit markets is likely to increase significantly.
Whereas before it didn’t matter who you lent to because volatility was suppressed, we believe investors need to focus on fundamental credit research in order to identify companies they can hold with conviction.
In summary, fixed income markets are at the epicentre of central bank distortions. What they are signalling now is discomfort at the divergent behaviour of central banks and their faltering influence altogether. Given their job is far from done we should be worried.
Victor Rodriguez is the head of Asia-Pacific fixed income at Aberdeen Asset Management.
