Is the real challenge for fixed income markets solely their valuations? Most measures from the global real economy point to stronger PMI, lower unemployment or increased GDP – all suggesting that rates should be higher. So why are Treasuries at their lowest yields this year?
US rates are in the tug of war between bond bulls and bears, with bulls currently having the upper hand. There is little doubt that the 1% increase since the end of 2015 has done little to dampen the US economy; the counter to this is that the economy has not run away either, seemingly regardless of significant swings in the dollar’s value. Cheap debt has fed into all aspects of rates and credit markets as financial repression reduces yields across markets. Are we in a goldilocks scenario? Or should we fear more than price itself?
There are signs of individual sector stress that aren’t as noticeable at an asset class level. Carmakers, typically with higher credit quality, are selling fewer units, while online retailers are redefining valuations for second-tier shopping malls. Credit market quality is also a subject of debate. Looking back to 2005/06, many corporates have slunk to lower credit ratings. But for the most part debt serviceability is not materially impaired, and financials’ credit quality is demonstrably stronger.
Maybe North Korea offers the opportunity to shake things up? Spread widening reactions so far to missile tests have been measured in Richter scale numbers (single digits) rather than nuclear equivalent, tonnes (hundreds). This points to markets with lower volatility, but could be an implicit bull signal. Certainly if it is only a war of words and further sanctions achieve the removal of uncertainty, this could prove bullish for credit markets.
Of course central bankers are really key to whether we should expect more of the same or not. They have been hyper-proactive in support of monetary policy and balance sheets have grown dramatically. We are now headed into a period where a reverse is the case. The Phillips curve and other econometric models that tell us to expect inflation to materialise from current levels of unemployment and growth are being challenged. Central bankers are the pilots frantically tapping their instrument gauges, knowing they need to land but have to do it on their own as well as negotiate the crosswinds of investor sentiment.
Markets expect an orderly removal of stimulus over a long period of time – and that orderly process is captured in current market valuations. A disruption to this view could cause meaningful market volatility and a back-up in valuations.