"Bond markets: my expectations"
Bond markets, long- and short-term interest rates, the dollar vs. the euro and political risks in 2017: Peter De Coensel, CIO Fixed Income de Degroof Petercam Asset Management, answers the questions by Thomas Van Rompuy, Senior Executive Advisor, while shining his light upon themes linked to portfolio management.Thomas Van Rompuy, Senior Executive Advisor.
Peter, what are your expectations for the coming years in terms of bond markets?
I think 3 elements will have a structural impact on long-term interest rates.
Firstly, a lot of forces supporting the thesis of a long period of slow growth are currently at play. For example, we’re seeing global productivity growth stagnate at a low level. Moreover, ageing populations in highly developed countries will slow down growth. This supports low real interest rates.
A second factor is based on the present surplus savings. The post-war boom combined with the baby-boomer generation has caused substantial surplus savings in the market. This results in unnaturally low interest rates due to an excessive supply of savings, combined with central banks using an expansive interest rate policy to try and move this mountain of savings along. Monetary policy then tries to encourage the consumption of savings or their transformation into lending.
Today we will gradually see the reverse effect. Baby boomers are retiring and will start using up their surplus savings, which will spur on consumption and inflation and could have a positive influence on real interest rates.
An additional force driving this development is the fact that emerging countries are increasingly focusing their policy on supporting national consumption rather than export and production alone.
The third element is investment. We have seen a dramatic drop in the level of government and corporate investment in recent years. More investment usually means more (potential) growth. If this trend does not abate and the level of investment remains structurally low, this will push real interest rates down as it limits potential growth and creates a focus on savings.
Considering all of these elements, we estimate that real global long-term interest rates could rise around 0.50% in 3 to 4 years, and another 0.50% in 10 years. This would amount to a gradual normalisation of the interest rate level.
This is further bolstered by increasing calls for more expansive budgetary policy in developed countries, with Central Banks indicating that they will adopt a less interventionist stance in the coming years (winding down the purchasing policy and normalising interest rates). However, this final element has not yet been fully priced in by the market.
Should we expect to see large discrepancies between the interest rates in the US and those in Europe?
Inflation expectations are increasing in both the US and Europe. Only a quick and decisive investment program by the Trump administration could push them up further in the short term. Aside from this, we foresee that the long-term 10-year interest rate will increase by around 0.50% or 50 bps in both the US and the EU towards the end of the year.
The most important difference, however, will occur on the short-term side of the interest rate curve. The ECB recently removed a limitation in its purchasing policy which prevented it from buying bonds on the market with interest levels below -0.4% (the ECB’s so-called deposit facility). This gives the ECB many more opportunities to purchase short-term bonds, causing further interest rate drops and increasing the discrepancy with long-term interest rates (the so-called interest rate curve will become steeper). This is good news for banks, which derive income from the difference between short-term and long-term interest rates.
What are your expectations regarding the dollar and the euro?
We have seen that the dollar is trading at a historically expensive price, but cannot see any reason why this would change in the short term. The Fed has hinted at several interest rate hikes while the ECB maintains its easy policy, supporting the dollar exchange rate. In addition, 2017 will be of great political importance to the Eurozone with elections in Germany, the Netherlands and France. This uncertainty will weigh down the euro/dollar rate.
The dollar will likely only start to decline if Trump were to garner support from all international stakeholders at a global level to devalue the dollar. However, we do not assume that such trade politics will be his first point of business. Trump will likely focus on national policy first.
What do you feel are the greatest financial risks we should take into account in the coming time?
First of all we are still seeing great fragility in our financial system. The Central Banks have purchased 13,000 billion dollars worth of financial assets: this is equivalent to over 30x the value of our Belgian GDP. This could cause distortions in terms of liquidity, sensitivity to interest rates, as well as the ‘spread volatility’ of corporate bonds.
Moreover, we need to keep an eye out for ‘grey swans’: uncertainties whose existence we are aware of, but whose outcome is unknown. For example, we know that the French will vote, but we do not know what the outcome will be.
As asset managers, we must carefully consider how we deal with these risks. We have opted for global diversification across the various bond sectors and will make considered choices for specific maturities when compiling bond portfolios. We must build in sufficient insurance and be able to react to evolutions in a timely manner.