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How to Prepare Your Portfolio for Rising Bond Yields and Inflation Expectations

  • Lyxor ETF

Ten-year treasury yields barely moved last year, despite three Fed rate hikes. As the early evidence this year suggests, this can’t last. Bond yields seem to have finally shaken off their indifference to policymakers’ steps towards monetary policy normalisation.

The global economy is in its best shape in a decade. The IMF has raised its forecast for global economic growth in 2018 and 2019, citing sweeping US tax cuts and their benefits to the world’s largest economy and its main trading partners. It’s no surprise bonds are in the eye of the storm.  

Nearing normal 

For all that, central banks are only likely to adjust their monetary policy stance gradually. Few will want to risk choking off a recovery they’ve tried so hard to stimulate. Many investors maintain some interest rate sensitivity via long-duration positions in their portfolios as a result. Staying true to this course may prove testing.

US and German 10-year yields are already up by around 25-30 basis points this year, although the less hawkish tone of the most recent central bank meetings suggests the pressure could abate at some point. In Europe at least, reflation dynamics and stronger growth now appear to be priced in. The European Central Bank’s (ECB) Public Sector Purchase Programme for 2018 still implies the bank will buy more debt than Germany will issue this year (on a net basis), which could also create a ceiling for yields – for now. Lyxor still expects yields to rise everywhere, albeit more gradually from here on in. 

Why bunds might outperform OATs in 2018Lyxor ETF

The ECB position is crucial. As recovery gathers momentum, the bank is busily preparing to bring its era of QE to an end. This could happen as early as September, with a rate hike as early as the start of 2019. Economic expansion alone justifies policy normalisation steps, even if inflation remains sluggish. The market now prices a normalisation of the deposit facility rate to 0 percent in late 2019. Anything more would mean a tightening of monetary policy in 2019, as opposed to rate normalisation only.

Readying for a new regime

In this environment, it’s a natural move to reduce interest rate sensitivity and defend against inflation by moving to asset classes with positive expected returns. As such, we prefer bonds of countries where inflation (or growth) is less likely to surprise to the upside and hasten more rapid rate rises. Japan appeals for example. We are also maintaining our position in peripheral eurozone bonds, believing tight spreads are unlikely to change while global risk appetite remains broadly buoyant. We favour Spanish bonds over Greek bonds, but politics clouds the issue for Italian BTPs yet again.

In the US, inflation expectations are increasing, helped by a tight jobs market (as seen in the January employment report). Wage inflation may finally be on the rise – especially if tax reform delivers as its architects believe it will. January data showed a 2.9 percent increase year-on-year in average hourly earnings. This, along with higher oil prices, could prompt a notable rise in US CPI from March or April onward. We like US breakevens and may look at eurozone issues later in 2018. Floating rate notes, and smart cash products, could help deal with the threat of rising rates, as could short duration bonds.

Read more on Lyxor’s inflation range.

With 10-year treasury yields touching 2.8 percent, 2-year treasury yields back at 2.05 percent for the first time since 2008, and the markets pricing in at least three hikes this year, we could be on the cusp of a regime shift. Yields of 3 percent+ on the 10-year treasury now appear a question of when, not if.

Finding it hard to take credit

Credit – notably high yield – remains a concern. Equity markets are reaching for the stars and credit spreads remain tight. Leverage has increased in both the US and Europe. Leverage alone does not create a credit crisis, but it does set the stage for one to occur. Debt growth has been outpacing GDP growth, and the most leveraged non-financial companies are those with the least cash. Furthermore, median balance sheet leverage in the US has returned to 2003 levels, i.e. the end of the telecoms crisis. As such, credit needs to be approached with caution. We prefer European issues to their American counterparts given the ECB will keep a heavy hand in markets at least through September

The global expansion needs higher real rates. They are likely to rise slowly but surely from here, and there is room for more as central banks look to adjust their monetary policy stance in line with the buoyant economy and rising asset prices. Bond investors, and bond yields, have been reluctant to accept this new environment, but this is set to change.

Check the latest yield news with Lyxor’s Interactive Tool.

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