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Market Comment April 2019 - Low Interest Rates, Low Yields - Why do Bonds Matter?

Why bond yields matter?

The first quarter ends with a rally both in equities and in bonds. Equities are sitting on solid gains while yields have tumbled, and the US yield curve has inverted. The 10-year Treasury yield has fallen below that of the three-month Treasury bill and in Germany, yields have turned negative for the first time since 2016.

The question is, of course, what do we read out of these rate moves? Yields indicate the markets expectation for future economic growth. Is this now a sign that global economic weakness is temporary or evidence that the expansion since the financial crisis is truly waning is legitimate. The same debate previously occurred in 2015 and early 2016. Then, huge fiscal stimulus from China, allied to bond-buying from the Bank of Japan and the European Central Bank, managed to end the soft patch. The election of US president Donald Trump, and the tax cuts that followed added momentum to global growth that eventually peaked early last year.

The double-digit gains for most equity markets this year have been helped by the signals sent by central banks that they are willing to ease policy, or, in the case of the Federal Reserve, sit on the sidelines. It has had the effect of loosening financial conditions, helping equities and credit.

The decline in bond yields can be seen across developed economies, suggesting a slowing China is having a global effect. Two of the bond markets at the forefront of lower yields have been Canada and Australia. While the housing markets in both countries are under pressure and yields are dropping may signal that this time around Beijing’s stimulus may not be enough to shore up growth.

The fact that falling bond yields is a global phenomenon also eases the selling pressure on the US dollar. A firmer reserve currency tightens financial conditions too, hardly a welcome development for US companies given the exposure of US blue-chips to the global economy. With the Fed stuck on policy pause and still trimming its balance sheet until September, at some the equity market may start fretting about a restrictive monetary policy, particularly if the dollar appreciates further.

A stronger currency and long-term yields lower than the short-term rates send a signal to the Fed that policy is too restrictive. The bond market is not forecasting a recession; it is simply flagging a higher risk of one. Clearly, the market turmoil of late last year showed the limits of the world’s most important central bank’s effort to tighten policy. That explains the confidence of fixed-income investors who are looking beyond the current cycle and already anticipating the next move from the Fed to cut rates.

A decade after the last global recession, equities and credit are expensive, and now likely to rise further courtesy of lower bond yields. What does this mean for your investment strategy?

We are clearly at the end of a long economic expansion and rates are set to remain low. Bonds are unlikely to offer any true returns and therefore equities remain one of the few options to pursue. If the global economic data improve in coming months and Washington and Beijing strike a trade deal, then financial markets could be soothed for a while. Low(er) interest rates will support equities for a while longer even if the markets are likely to become even more volatile. We look for companies that disrupt their market and offer growth independently of the major market trends.

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