Don’t bank on a hike just yet


Jonathan Platt, Head of Fixed Income

29 June 2017

This week’s sudden spike in government bond yields is showing few signs of a reversal on Thursday, suggesting that markets have been caught unprepared for a tightening of monetary policy. Hints this week that Mario’s ‘Magic Money Tree’ might begin to be tapered led to a tumultuous sell-off in European government bonds, which was partly reversed as the European Central Bank (ECB) clarified comments on Wednesday. Meanwhile a surprisingly hawkish Mark Carney has further spooked the gilt market, with short-term yields hitting new highs for 2017 and trading ever closer to pre-Brexit levels.
However we’re surprised by the scale of the sell-off. It has been clear for a long time that the easy monetary policy which had anchored government bond yields could not last forever, the question for markets was not if but when. However, given that recent wage growth remains soft and unsecured lending looks likely to be squeezed, the Bank of England is unlikely to apply further pressure to UK consumers. Therefore, where appropriate we’ve taken advantage of this week’s weakness to selectively purchase assets which we feel may have been over-sold.
Aside from moves in government bond yields, Royal London Asset Management’s fixed income team share three key trends shaping bond markets this week:
1. Are we hiking yet?
Gilt markets finally broke free of the trading range they’d been sitting in for the past 60 days, with short dated paper now offering a yield higher than the current Bank of England (BOE) base rate. However, with markets still choppy, at the front end of the yield curve there has been less steepening than we’d expect if the Bank really was planning on raising rates, suggesting that some investors are still fairly skeptical about any radical change in UK policy in the near future.
2. Seniority matters in credit
In a week of rescue stories for failing lenders, various bond holders have been reminded of why it’s important to consider where they sit in a bank’s capital structure. While the bailouts of Banca Popolare di Vicenza and Veneto Banca, along with a recapitalisation of the Co-op bank, led to pain for holders of Additional Tier 1 bonds (AT1s), investors holding senior financial bonds have been protected, leading to outperformance in that sector. Meanwhile, recommendations from the BOE to UK banks to increase their capital buffers in case of a consumer credit crunch have further boosted financial bonds which boast this seniority. 
3. High Yield investors fight back
While demand for attractive yield and a remarkable rally has recently seen a wave of price tightening and looser covenants in high yield bonds, investors are now fighting back. In both the high yield and leveraged loan markets investors are becoming price makers once more, with deals from Klöckner and Manutenkoop facing pushback from investors and offering higher spreads than those initially suggested to the market.

This week’s sudden spike in government bond yields is showing few signs of a reversal on Thursday, suggesting that markets have been caught unprepared for a tightening of monetary policy. Hints this week that Mario’s ‘Magic Money Tree’ might begin to be tapered led to a tumultuous sell-off in European government bonds, which was partly reversed as the European Central Bank (ECB) clarified comments on Wednesday. Meanwhile a surprisingly hawkish Mark Carney has further spooked the gilt market, with short-term yields hitting new highs for 2017 and trading ever closer to pre-Brexit levels.

However we’re surprised by the scale of the sell-off. It has been clear for a long time that the easy monetary policy which had anchored government bond yields could not last forever, the question for markets was not if but when. However, given that recent wage growth remains soft and unsecured lending looks likely to be squeezed, the Bank of England is unlikely to apply further pressure to UK consumers. Therefore, where appropriate we’ve taken advantage of this week’s weakness to selectively purchase assets which we feel may have been over-sold.

Aside from moves in government bond yields, Royal London Asset Management’s fixed income team share three key trends shaping bond markets this week:

1. Are we hiking yet?

Gilt markets finally broke free of the trading range they’d been sitting in for the past 60 days, with short dated paper now offering a yield higher than the current Bank of England (BOE) base rate. However, with markets still choppy, at the front end of the yield curve there has been less steepening than we’d expect if the Bank really was planning on raising rates, suggesting that some investors are still fairly skeptical about any radical change in UK policy in the near future.

2. Seniority matters in credit

In a week of rescue stories for failing lenders, various bond holders have been reminded of why it’s important to consider where they sit in a bank’s capital structure. While the bailouts of Banca Popolare di Vicenza and Veneto Banca, along with a recapitalisation of the Co-op bank, led to pain for holders of Additional Tier 1 bonds (AT1s), investors holding senior financial bonds have been protected, leading to outperformance in that sector. Meanwhile, recommendations from the BOE to UK banks to increase their capital buffers in case of a consumer credit crunch have further boosted financial bonds which boast this seniority. 

3. High Yield investors fight back

While demand for attractive yield and a remarkable rally has recently seen a wave of price tightening and looser covenants in high yield bonds, investors are now fighting back. In both the high yield and leveraged loan markets investors are becoming price makers once more, with deals from Klöckner and Manutenkoop facing pushback from investors and offering higher spreads than those initially suggested to the market.

The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. The views expressed are the author’s own and do not constitute investment advice.