From rescuer to foe: how central banks threaten next year's market performance

Bonds
Althea Spinozzi

Senior Fixed Income Strategist

Summary:  Overly accommodative monetary policies have been central banks' medicine of choice to support an economy struck by the Covid-19 pandemic. The only problem: the side effects start showing. A rise in inflation, higher interest rates and a spike in corporate defaults are key risks which may spur directly from excessively easy monetary policy. In 2021 bond investors will need to seek protection against inflation, to diversify risk and stagger maturities.


We are about to turn the page of a peculiar year where an unexpected Covid-19 pandemic has turned into an unprecedented market opportunity for many, including bond investors.

Central banks ultra-loose monetary policies have contributed to a rally in government and corporate bonds globally, pushing yields to record low levels. The monetary and fiscal response to the economic crisis has been unprecedented. The IMF estimates that developed economies' combined fiscal and monetary stimulus sums up in some cases to be as high as 20% of their gross domestic product.

In short, central banks globally have been forced to make a quick U-turn in order to navigate the pandemic. The Federal Reserve quickly steered away from the possibility to tighten its monetary policy. Across the Atlantic, the European Central Bank expanded and created new programs to print even more money to support the economy. At the same time, European countries moved away from austerity, issuing more and more debt to sustain their economies.

Now that we are coming to the end of the year, it is impossible to ignore that significant risks have arisen directly from such accommodative monetary policies. Although the market seems to dismiss them, we believe that investors should prepare for the real possibility that central banks could make a monetary policy mistake next year.

1. Inflation leading to fiscal or monetary policy tightening

It is a tail risk that is hiding in plain sight. Investors are overly confident that inflation will not overshoot expectations. Some argue that the Federal Reserve's new average inflation targeting (AIT) approach should give ample room for the market to reposition before the central bank hikes interest rates. However, will ever the market resolve that we are entering an inflationary environment? Several inflation indicators such as the 5y5y forward CPI swap and the 10-year USD zero-coupon inflation swap are already above the 2% level. The 10-year Breakeven rate is also about to approach this figure.

Source: Bloomberg.

Treasury inflation-protected securities are also suggesting that inflation is on the rise and that a part of the market may be preparing for it. TIPS have been outperforming Treasuries for a couple of years now, and while US Treasuries have hit a record low yield at 0.50% this year, 10-year TIPS yields have fallen into negative territory at the beginning of the year to hit -1% recently. TIPS constitute only 11% of the Treasury market, meaning that they are undersupplied. Thus, in the case of inflation, underpinning demand will continue to support high valuations.

Although the Fed is committed to holding interest rates low for longer, a democratic president will enter the White House in a few weeks, and he will look to inject liquidity to support the US economy as the Covid-19 vaccine gets rolled out. With the current monetary stimulus in place, an increase in money supply will increase the chances of inflation to rise, probably leading to monetary policy tightening.

In this scenario, the bullish market sentiment spurred by dovish central banks policies can quickly vanish provoking unprecedented volatility across all assets.

2. Interest rates and dollar shock

The direct consequences of higher inflation and monetary policy tightening are higher interest rates and a lower US dollar.

It is important to note that while Treasuries have been offering lower and lower yields, the US yield curve has been steepening. A steepening of the yield curve can occur when longer yields rise faster than short-term yields (bear-steepener) and when short-term yields fall faster than long yields (bull-steepener). The latter has happened this year: the Fed has been cutting the federal fund target rate provoking a fast dive in short-term yields and provoking the US yield curve to steepen. The market has benefited from this trend because as the front part of the yield curve was falling, the longer leg, although slower, was following suit.

Things will be different next year. We will continue to see the US yield curve steepening. However, this time around, yields will gradually rise for the previous point's very reasons.

Higher rates and a dollar shock will inflict pain to Treasuries and US corporate bonds. Longer maturities will be most vulnerable.

However, outside the US, emerging markets will gain out of a weaker dollar. That's why in such a scenario, emerging market bonds with short to mid-maturities with a buy-to-hold perspective can prove to be a good ally amid rising interest rates.

3. Zombie economy finally see a spike in corporate defaults

The massive injection of liquidity that the economy has been subjected to this year has prevented many bankruptcies. Yet, businesses were led to take on more and more debt surpassing levels that we haven't seen in almost 20 years (refer to below chart). As things go back to normality following the deployment of the Covid-19 vaccine, we can expect the economy to recover and less money to be printed. That's the time when zombie companies are going to find the toughest environment for survival, as the economy will most likely need a longer period of structural adjustment before returning to pre-crisis activity.

Therefore, it is vital to cherry-pick risk, especially when looking at lower-rated credits.

How can I protect my investments?

  • Diversification. Don't put all your eggs in one basket. This means that you might still keep your favourite stocks and bonds, but they shouldn't be your only investments. You can promptly achieve diversification by buying ETFs. Exchange-Traded Funds are an excellent tool to gain exposure to various instruments, sectors and investment objectives. For example, in case you see opportunities in emerging markets corporates, but you are not comfortable in picking one particular company you can have a look at the iShares J.P. Morgan EM Corporate Bond ETF (CEMB) which give you exposure to US dollar-denominated corporate bonds issued in the emerging markets. ETFs can provide you also the opportunity to invest in local currency debt such as the SPDR Bloomberg Barclays Emerging Market Local Bond -ETF (EMDE).

  • Get protection against inflation. TIPS are a great tool when it comes to hedge against inflation. However, if you don't feel comfortable trading them, you can find many ETFs that can help you to achieve this goal. The Vanguard Short-Term Inflation-Protected Securities (VTIP), Schwab US TIPS ETF (SCHP) and PIMCO 15+ Year US TIPS (LTPZ) are some of the instruments you can find and trade on the Saxo Platform.

  • Consider stagger maturities. A ladder strategy is used when one seeks to invest in bonds with different maturities. As the first one matures, you will be able to reinvest in higher-yielding notes.

Disclaimer

The Saxo Bank Group entities each provide execution-only service and access to Analysis permitting a person to view and/or use content available on or via the website. This content is not intended to and does not change or expand on the execution-only service. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Saxo News & Research and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Bank Group by which access to Saxo News & Research is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Bank Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Bank Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Saxo News & Research or as a result of the use of the Saxo News & Research. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Bank Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. Saxo News & Research does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws.

Please read our disclaimers:
Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)
Full disclaimer (https://www.home.saxo/legal/disclaimer/saxo-disclaimer)
Full disclaimer (https://www.home.saxo/legal/saxoselect-disclaimer/disclaimer)

Saxo Bank (Schweiz) AG
Beethovenstrasse 33
CH-8002
Zürich
Switzerland

Contact Saxo

Select region

Switzerland
Switzerland

All trading carries risk. Losses can exceed deposits on margin products. You should consider whether you understand how our products work and whether you can afford to take the high risk of losing your money. To help you understand the risks involved we have put together a series of Key Information Documents (KIDs) highlighting the risks and rewards related to each product. The KIDs can be accessed here or within the trading platform. Please note that the full prospectus can be obtained free of charge from Saxo Bank (Switzerland) ltd. or the issuer.

This website can be accessed worldwide however the information on the website is related to Saxo Bank (Switzerland) Ltd. All clients will directly engage with Saxo Bank (Switzerland) Ltd. and all client agreements will be entered into with Saxo Bank (Switzerland) Ltd. and thus governed by Swiss Law.

The content of this website represents marketing material and has not been notified or submitted to any supervisory authority.

If you contact Saxo Bank (Switzerland) Ltd. or visit this website, you acknowledge and agree that any data that you transmit to Saxo Bank (Switzerland) Ltd., either through this website, by telephone or by any other means of communication (e.g. e-mail), may be collected or recorded and transferred to other Saxo Bank Group companies or third parties in Switzerland or abroad and may be stored or otherwise processed by them or Saxo Bank (Switzerland) Ltd. You release Saxo Bank (Switzerland) Ltd. from its obligations under Swiss banking and securities dealer secrecies and, to the extent permitted by law, data protection laws as well as other laws and obligations to protect privacy. Saxo Bank (Switzerland) Ltd. has implemented appropriate technical and organizational measures to protect data from unauthorized processing and disclosure and applies appropriate safeguards to guarantee adequate protection of such data.

Apple, iPad and iPhone are trademarks of Apple Inc., registered in the U.S. and other countries. App Store is a service mark of Apple Inc.