Fixed income

Post US interest rate hike: reflation trade check-in

Ben Edwards |17-Mar-2017

UK government bond yields have defied the reflation rhetoric and material increases in US treasury yields. Ben Edwards assesses the impact of the latest US rate hike.

Like all good construction jobs, building corporate bond portfolios requires solid foundations. Post the recent US rate hike, amidst the much touted “reflation trade” and with volatility events in Europe looming, it’s worth checking in on the foundation of our sterling bond portfolios, the ten-year Gilt. A relatively stable base, after all, allows high quality corporate bonds to perform well as investors have visibility on what their future coupon income will likely be worth.

Read more: Factoring in reflation

UK government bond yields have defied the reflation rhetoric and material increases in US treasury yields to put in a remarkably steady performance recently. In fact, current ten year yields of around 1.25%1 are roughly the same as a week before the Brexit vote in June last year and a week prior to the US presidential election in November – two key drivers of bond market volatility. It’s worth highlighting that since the Brexit vote itself, ten-year Gilt yields have fallen around 0.30%2, generating close to 4%2 of positive returns while ten-year Treasury yields have risen 0.80%2, generating a loss of around 6%2. These divergent paths of yields highlight the diverging outlook for growth, inflation, monetary and government policy that began in June last year.

The forces affecting yields

Yields in the UK are being pulled by two opposing forces – on one side the shift higher in global (read US Treasury) yields and on the other side a far more subdued outlook for economic activity and enhanced political uncertainty in the form of Brexit and a potential second Scottish independence referendum. A look through the revised Fed “Dot Plot” initially suggests an outlook for future US rate hikes little changed from last December, but closer scrutiny shows a committee where the hawks have held firm to their views while the doves have capitulated materially. The median expectation is now for two more hikes in 2017 and a further three next year. Contrast this with the market’s current expectation for UK policy action: one hike late in the summer of 2018.

Inflation outlooks too, show a contrasting picture. US core inflation which is currently 2.2%3 (having run up from 1.6% at the start of 2016) is widely expected to approach the heady 2.5%+ levels of the pre-GFC world over the coming year. UK core inflation, however, has been much more stable at 1.6%4, off the 2015 lows, to be sure but more or less where it was three years ago. With the easy wins from energy price rebounds seemingly done and a business investment outlook significantly less conducive to wholesale wage pressure, the inflation debate in the UK will likely be dominated by the value of the pound – as it has been since the Brexit vote. It is also worth remembering that our experience with a Brexit related weakening currency so far has been that the expected negative effects of lower potential real growth have outweighed increasing inflation expectations and government bond yields have actually fallen, delivering positive returns for investors.

The median expectation is now for two more hikes in 2017 and a further three next year

Policy divergence

Government policy, too has diverged. And while the new US president attempts to rally his party around tax cuts and fiscal stimulus just as the economy may be nearing capacity, the UK government is attempting (somewhat unsuccessfully) to continue tightening the government's belt. In almost every way these economies seem to be heading in different directions.

Clearly, rapidly falling yields over the past years have been a boon to bond investors, the Blackrock Corporate Bond fund has returned 41.3%5 over the last five years. Investors shouldn’t expect these sorts of returns for the next five years but that is no bad thing. Nothing is certain and while we remain constructive on corporate bonds over the long term we appreciate that the “reflation trade” provides a challenging backdrop in the near term.

We remain wary of taking unduly high duration risk (like that reflected in many fixed income benchmarks) and we take a cautious view of the very long end of the bond market, even in the UK – where extra volatility is seldom rewarded. But ultimately, we believe a relatively stable gilt yield will continue to provide a strong foundation for corporate bonds to do the very simple job they have – to produce low risk, high quality income and enhance diversification within investor portfolios.

1Source: Bloomberg, 16 March, 2017
2Source: Bloomberg, 16 March, 2017
3Source: Bloomberg, February 2017
4Source: Bloomberg, January 2017
5Source: BlackRock Corporate Bond Fund (Class D) cumulative return (£), net of fees, over five years to February 28, 2017. One year return to February 28, 2017 is 11.6%. Three year return to February 28, 2017 is 21.4%. Since inception return to February 28, 2017 is 47.6%. Performance is shown on a bid to bid price basis, with net income reinvested. Past performance is not a guide to future performance.

Ben Edwards
Director, lead fund manager of BlackRock Corporate Bond Fund and co-manager of the BlackRock Sterling Strategic Bond Fund
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