A muted market reaction
However, the lack of a US rate rise and a surprisingly dovish Fed statement was greeted by slippage across equity and other risk markets – something that hints at weariness and more worryingly an indication that policymakers’ lack of confidence is transferring to investors. We appear to have reached a point where zero interest rate policy (ZIRP) has been milked dry and investors now want their expectations on GDP to be met by reality. We are increasingly of the belief that ZIRP in itself should be ignored as a catalyst for change, and that monetary policy is best judged on a narrow focus of whether GDP is sustainable and inflation targets look achievable.
In these narrow terms under which bonds now operate, a delay in rate hikes could well be sufficient to sustain yields at eye-wateringly low levels. At best, this is an understandable experiment bearing in mind the fragility of growth, with no immediate inflationary impetus in sight. At worst it is an active policy to ensure inflation is pushed higher using global crosscurrents as a smokescreen. At this stage of the business cycle there is no margin for any sort of error built into either bond or
yield curve pricing.
Our strategy within global government bonds
Against this background, our strategy is to be pragmatic – a confusing economic picture has just become more opaque, pressures may well prompt an extension of ECB or
Bank of Japan QE, and despite six years of unprecedented stimulus inflation remains well below target levels across the major economies. However, all core bond markets
remain exceptionally expensive on a number of historical relationships. Ultimately, without a re-emergence of anything approaching quasi-forward guidance we consider that the proximity of a cyclical turn will continue its recent dampening influence on the US Treasury market, leaving it a laggard. The Yellen Fed is increasingly, and understandably, trying to boost inflation back towards target, but this leaves both the yield curve too flat and long-term inflation pricing offering value. In
our view, the UK economy shares many of the characteristics of the US and so the bond market is equally as vulnerable as the US if capacity pressures emerge. We see Europe as the best supported and, under an extension of policy by an emboldened ECB, peripheral debt markets could perform relatively well.