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.
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.
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