Fixed income: A tactically underweight duration
A sharp decline in long-term government bond yields went in line with the sharp deterioration in market sentiment for fixed income markets in Q4.
In fact, December’s decline in US 10-year Treasury yields was the largest in volatility adjusted terms since the market sell-off of 2016 (figure 1).
Back then, markets similarly sold off in response to growth and deflation fears.
We believe that just as in 2016, current rate expectations have become too pessimistic. In this sub-piece, we’ll outline why.
When it comes to analysing long-term rates, a helpful starting point is to recognise that the term structure of the interest rates is mainly comprised of two components – a compensation (also known as risk premium) for both expected and unexpected inflation, as well rate expectations (the expected path of monetary policy).
Simplistically, changes in long-term rates are primarily driven by variations in both components. Over the past two months, we've seen a simultaneous fall in both.
Deflated inflation expectations
Firstly, inflation expectations have been revised significantly lower over the course of Q4 2018 (figure 2).
In our view, this is partially driven by the 35% plunge in oil prices.
A shock of this magnitude is bound to exert a meaningful impact on near term inflation prospects via both direct and indirect effects in consumer expenditures.
Longer-term however, the disinflationary effects should wash out from the inflation numbers due to base effects.
Meanwhile, we expect a tightening labour market to continue exerting upward pressure on US core inflation over the medium-term.
On balance, we think that inflation expectations have fallen below levels justified by the incoming macro data.
Are interest rate cuts ahead?
Turning to the second driver, we’ve observed that markets have dramatically scaled back rate expectations for 2019.
This re-pricing appears most evident in the US, where investors are now anticipating rate cuts from the Fed by early 2020, as opposed to rate hikes from the previous quarter.
To us, the drastic revisions are likely a response to the ongoing moderation in activity indicators.
Industrial/manufacturing data from the Eurozone and China have been disappointing throughout Q4, pointing towards further downside in growth for Q1 2019.
Meanwhile in the US, the positive growth impulse from fiscal stimulus is widely expected to fade this year.
Together, these factors have resulted in growth expectations being revised downwards – hence the retreat in rate expectations.
However, a Q1 2020 rate cut from the Fed looks unlikely in the context of the current macro-environment, where labour market conditions remain healthy and inflation remains barely on target.
Recession or rebound?
For now, we interpret the latest data as pointing towards a further slowdown in growth, rather than an outright recession in 2019.
Overall, we think that investors have likely adjusted their rate expectations too far.
Given our views that both inflation and rate expectations have overcorrected, we see scope for a rebound in both measures as sentiment recovers.
Hence, we recently initiated a tactical underweight in developed government bonds within client portfolios, with the intention of capturing an anticipated rebound in long-term rates.
Here, we made a conscious decision to exclude UK Gilts from this move.
While Gilt yields have trended lower in line with global yields late last year, driven also by falling inflation expectations, the event risk surrounding Brexit makes us wary of taking any high conviction views on Gilts at this point in time.