We are at a critical point in the cycle of bond prices at the moment. The way in which stock-and bond-prices interact will influence how both develop over coming years. This article outlines the context of this interaction, where we are now, and the implications for investors.
After the financial crisis, banks and borrowers were overburdened with debt. As a result, lending was grinding to halt which threatened the entire financial system. The Bank of England was among the central banks that reacted by reducing interest rates to all-time lows. But that was insufficient as interest rates had already become quite low, so the effect was limited.
Central banks in the US, Europe, Japan and the UK had to find an alternative way of stimulating both borrowing and inflation (which was falling too quickly). The method they chose was to introduce new, additional cash into the financial system.
In the past, this would have been done by printing new bank notes. But most money these days is held electronically in bank balances. So central banks had to electronically “print” money.
They did this by buying bonds that financial institutions such as banks were holding. That provided banks with (electronic) cashwhich they could use to shore up their own finances and lend to individuals and businesses. The process was referred to as quantitative easing (QE).
It took a while to take effect, but after a couple of years the financial system started to regain its poise, and economic growth returned. This growth was largely dependent on central banks continuing to pump cash into the system. So the banks continued their QE operations and share prices rose in response to the improved financial conditions.
In order to be effective, the central banks involved in QE bought trillions of dollars-worth of bonds. Inevitably, this had sideeffects.
Firstly, it drove up the prices of the bonds that central banks were buying. These tended to be the lower-risk rated government bonds such as 10-year Treasuries. The price and yield of a bond move in opposite directions. With those bond prices rising, their yields were being pushed down. The yield is the return that investors receive for holding bonds and is heavily influenced by the level of risk associated with the given bond.
Investors buying these bonds for their yields were left with the choice of either accepting lower returns or increasing the risklevels in their portfolios by buying higher-risk rated bonds. Once again, as the demand for other, higher-risk rated bonds, sending their prices up and their yields down.
This knock-on effect spread across bonds of all risk levels as investors had to choose between falling yields or higher risk.
As time went on, there were insufficient of the lowest-risk rated bonds available for central banks to buy, so they had to buy slightly higher-risk rated bonds including corporate bonds (those issued by companies).
This pushed bond prices higher and higher, forcing yields ever lower. Bond yields reached all-time lows with German government bonds “paying” negative interest rates for a while, i.e. effectively charging the investor for holding them.
The distortions weren’t limited to price and yield. Before the central banks waded in, bond markets were kept running in partthanks to “market makers”. These are large financial institutions that guarantee to buy or sell a certain volume of a given asset. That way, there is always a minimum level of supply and demand, or “liquidity” as it is called.
With central banks having delivered huge volumes of liquidity, market makers were no longer required in some bond markets. Atthe same time, policymakers were imposing substantial new legislation designed to protect the banking system from a repeat of the excesses that led to the financial crisis.
This new legislation created an expensive and time-consuming burden for market makers, many of whom withdrew from some bond markets. While central banks continued to buy bonds, this was not a problem. But that situation is now changing.
Recent rises in inflation have enabled some central banks to reduce their financial stimulus measures by increasing interest rates and reducing, or even reversing, their QE programmes. Meanwhile, the trend of rising stock prices is under threat from slowing global economic growth, international trade tensions, European Union disruption due to the UK’s departure and Italy’s populist politics, as well as geopolitical issues such as those affecting Venezuela and Iran which could push oil prices and inflation up just as economic growth begins to slow.
This combination presents a challenge for central banks because they have to balance economic growth with the need to keep inflation under control. Stimulus measures such as low interest rates or the continuance of QE tend to increase both inflation and growth.
But there is a second challenge that has taken its toll twice in the past year or so. In January 2018, the effects of banks reducing or reversing their QE programmes started to push the demand for and price of bonds down. That sent their yields up which made them more attractive. Investors looking to find the optimal balance between risk and return saw an opportunity to move from equity to bonds. That helped to trigger a sharp fall in equity priceswhile stimulating the demand for and price of bonds.
The situation more or less repeated itself in October when the outlook for corporate profits began to wane while some centralbanks (most notably the US Federal Reserve) continued to increase interest rates while also selling some of the $4.5 trillion of bonds that it had amassed. Other factors combined to keep stock prices falling into December though they have since staged a partial recovery.
Today, we face a situation in which the Federal Reserve has announced the suspension of both interest rate rises and the sellingof its stack of bonds to allow inflation, economic growth and investor confidence to stabilise.
Our analysis suggests that corporate profits will continue to be healthy for 2019, but the near-term future beyond that is less certain.
One of the areas of vulnerability is in bond prices. They are still near all-time highs, so we expect the long-term trend to be downward. That said, investors will continue to react to various unpleasant surprises (such as the India-Pakistan tensions or disappointing corporate results), and that probably means occasional boosts to bond prices.
Forecasts are opinion only, cannot be guaranteed and should not be relied upon when making investment decisions. The forecastoffuture performance is not a reliable guide to actual future results. Past performance is not a guide to future performance. Investors may not receive back the full amount originally invested and the value of investments, and the income from them, may fall as well as rise. No representation, warranty, express or implied, or undertaking is given or made as to the accuracy, reasonableness or completeness of the contents of this document or any opinions or projections expressed herein.
Investment markets and conditions can change rapidly and as such the views expressed should not be taken as statements of fact, nor relied upon when making investment decisions. Any views expressed within this report are our in house views as at March 2019 and should not be reliedupon as fact and could be proved wrong. The information contained in this document has been derived from sources which we consider to be reasonable and appropriate. This document may not be used, copied, quoted, circulated or otherwise disclosed (in whole or in part) for any other purpose without prior written consent.
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