By Oliver Sinnott, Director – Bond Fund Management, IQ EQ Fund Management (Ireland) Ltd
In recent weeks, we in IQ-EQ’s Fund Management team have been increasing fixed income weightings across many of our portfolios. We see the strains on the U.S. regional banking sector as a potential game changer. This is not to say that we believe this is the 2008 Global Financial Crisis all over again, but rather that it is likely to reduce lending to the U.S. economy and slow growth. We believe this strengthens the case for high-quality government bonds.
Hiking cycle almost done
Over the past year, central banks have been acting very aggressively to curb inflation. The U.S. Federal Reserve, for example, has raised rates by 5% during this time – one of the most aggressive tightening cycles in its history. Interest rate hikes dampen growth and inflation by raising the cost of finance for households and businesses. These increases work with a time lag, so their true impact has yet to be felt, but we are already seeing evidence of pressure on the most interest rate-sensitive parts of the global economy.
In addition, with the recent regional bank failures we are beginning to see financial “accidents”, which are tell-tale signs that we are in the latter stages of the tightening cycle. These come on top of earlier casualties in the cryptocurrency market.
Although we keep an open mind, we believe the fall of Credit Suisse may be an idiosyncratic event and not reflective of stresses in the European banking system.
Credit crunch?
Whether there are more skeletons in the U.S. regional bank closet remains to be seen. However, even if the banks mentioned turn out to be isolated cases (thanks in large part to the swift and extraordinary liquidity support from the U.S. authorities), we think recent events will result in less lending to the U.S. economy over the coming months.
This is because we think smaller banks are likely to turn conservative in their lending practices, fearing further deposit flight, and perhaps more importantly, because they will be preparing for stricter regulations coming down the line. This could slow growth and may even risk a recession. Given the U.S. economy’s importance to the global economy, it may also slow global growth and inflation.
Long dated bonds can rally
This scenario would be unequivocally positive for high-quality government bonds. Central banks should now be closer to pausing their respective hiking cycles, which has historically been a good time to buy bonds. And even if we enter a relatively mild recession and central banks are reluctant to cut interest rates because of stubbornly high inflation, long dated bonds have room to rally significantly.
The stresses now seen in certain parts of the economy and financial markets (with lags in the transmission of recent hikes still to be felt) are evidence that central bank interest rates are now in restrictive territory. This would imply that once inflation has normalised, the longer-term path of future interest rates should be lower. In addition, long term inflation expectations, whether measured by surveys or market-based instruments, have remained well anchored – unlike the last episode of high inflation in the 1980s. This is further supportive of long-term bond valuations.
Asymmetric return profile
Of course, it is possible that we are not near the interest rate peak. Growth may accelerate and/or inflation may remain high, which could put further upward pressure on bond yields. However, if this proves to be the case, the good news is that bond yields are now higher after the dramatic sell-off in 2022 and income can now significantly help offset the capital loss if yields rise.
Take the 10-year U.S. Treasury Note yielding 3.5% at the time of writing as an example. All other things equal, yields would have to rise above 4% (source: Bloomberg, as at market close on 8 May 2023) to lose money on a 12-month view given the extra coupon income earned during the period. However, if a recession were to materialise, the bond’s yield would fall (price rise) and a double-digit return would be likely in our view.
Taking this attractive risk-return profile into account, we think it is prudent to have an allocation of high-quality government bonds within balanced portfolios. Given higher funding costs and potentially less credit availability, the bar for any marginally profitable business or investment to stay afloat has been raised considerably over the past year. More accidents may be waiting in the wings and allocating to bonds may help to protect portfolios against future downside risk.
