How Will Ongoing Interest Rate Divergence Impact Bond Markets?
Jenna Barnard, Co-Head of Strategic Fixed Income, explains how the persistence of interest rate divergence remains central to the team’s thinking on the outlook for the bond markets.
- Bond markets will likely be dominated by interest rate divergence across developed economies over the next few years.
- Central banks in a number of economies such as Australia and Europe simply do not have the impetus to hike rates, but some have followed the U.S. Federal Reserve, such as Canada.
- Divergence in interest rates can create opportunities to actively manage duration.
When we think about the outlook for bond markets, the key theme for us, really for the last four years, has been that of interest rate divergence. This is a really unusual cycle for bond investors with the Federal Reserve pushing ahead with rate rises, but central banks in other countries struggling to hike rates much, if at all.
And that kind of environment really hasn’t been this extreme since the 1980s, so it’s unusual. We think it will persist. And the reason we think it will persist is that there are many structural impediments to growth and inflation in developed economies around the world.
So if you take the case of Australia where you’re experiencing consumer deleveraging and a deflating housing market, it’s an economy that’s had very low wage growth relative to the past over the last few years and where inflation is struggling to meet target. So in that economy, there’s just very little impetus or reason for the central bank to hike rates.
In the case of Europe, we see many parallels to Japan in terms of demographics and debt deleveraging. And there’s obviously the structural fault line of Italy and some other countries within Europe.
So every country outside of the U.S. has particular problems and impediments to hiking rates. That doesn’t mean that no central nank will hike rates. Canada’s obviously pushed ahead following the Fed, but there are opportunities to exploit when the market overprices rate hikes in certain countries and when we disagree.
So that’s the key theme for us, interest rate divergence. The average range in 10-year U.S. Treasury yields over the last 10 years is over 100 basis points peak-to-trough in any calendar year, so we find opportunities to fade the extremes both in yield lows and yield highs because investor emotion and positioning tends to give opportunities in most calendar years.
So for us, we’ll continue to look at that theme of interest rate divergence. We expect it to persist, as I said, and look to manage duration actively. We think it’s very unlikely that we’re at the beginning of a major bear market in bond yields in the U.S. and we have a very different perspective on the world having looked at the experience of Japan, Europe and many of these developed economies where we’re struggling to get inflation up to target and wage inflation in any meaningful way.
Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.
Foreign securities are subject to additional risks including currency fluctuations, political and economic uncertainty, increased volatility, lower liquidity and differing financial and information reporting standards, all of which are magnified in emerging markets.
Basis Point (bp) equals 1/100 of a percentage point. 1 bp = 0.01%, 100 bps = 1%.
Duration measures a bond price’s sensitivity to changes in interest rates. The longer a bond’s duration, the higher its sensitivity to changes in interest rates and vice versa.