CARMEN NEL: Mr Bond is back, investors no longer have to reach for yield

Excessively loose monetary policy since the onset of the global financial crisis in 2008 led to distortions in financial market asset prices. US and eurozone central bank policies of Zirp (zero interest rate policy), Nirp (negative interest rate policy), and QE (quantitative easing) pushed equities sharply higher.

The S&P 500 in particular was the star performer as plummeting long-term bond yields, with certain nominal yields trading in negative territory, left investors without many options. And so the acronym Tina — “there is no alternative” — was born.

The aggressive policy response during the Covid-19 pandemic worsened the performance concentration in US equities as ratings surged on near-zero discount rates amid a boost to earnings from fiscal stimulus.

This “free money” was not without a cost. Inflation surged in developed markets as demand outpaced supply across raw materials, goods and, more recently, services markets. Central banks are now responding with force to dampen price pressures and ensure that inflation expectations remain anchored. The confluence of higher inflation, rising policy rates and quantitative tightening has pushed developed market bond yields meaningfully higher.

The US 10-year benchmark bond yield has risen from a pandemic low of 0.5% to almost 4%, while the German equivalent has climbed from -0.6% to 2%. US inflation-linked bonds — called Treasury Inflation-Protected Securities (Tips) — have reset from -1% to 1.5% over the past six months. With 12-month US deposit rates at almost 5%, we have moved from Tina to Tara — “there are reasonable alternatives”.

Even for SA-based investors developed sovereign bond and money markets have now become viable asset classes. However, bonds should not be seen as boring. The recent market gyrations reveal significant volatility in asset classes that were historically deemed as being “safe”.

A case in point is the reaction of UK markets to the government’s proposed tax cuts and subsidies. While there were various technical factors at play that worsened the move, gilts and pound sterling did not like the idea of adding to inflation at a time when the Bank of England was trying to catch up with long overdue policy rate increases. The extent of the market moves risked systemic damage, forcing the Bank of England to buy bonds, and leaving the bond vigilantes unsuccessful in making the government change fiscal tack.

Global inflation

Global inflation risks and exogenous price pressures have also spurred the SA Reserve Bank into more aggressive action in recent months. This hawkish stance is reflected in short-term interest rates normalising off the extreme Covid-19 lows. The three-month money market yield has risen to almost 6.5%, while the 12-month equivalent is now above 8%. The last time it was this high was in 2016, when the Bank was hiking interest rates and the implementation of Basel III was still making its way through the banking system. Even locally the short end of the yield curve is now able to compete with riskier assets when looking at prospective returns on a risk-adjusted basis.

With savers no longer having to reach for yield or take on excessive risks to make retirement ends meet, riskier assets might be vulnerable despite better valuations. For the local investor the increase in the offshore allowance under Regulation 28 and improving developed market bond yields could combine to reduce demand for domestic assets. Similarly, higher money-market yields could shift investment demand out of longer-term instruments into shorter-term instruments.

Domestic savings pool

This has significant macro implications considering the stagnant, albeit large, domestic savings pool, as well as in relation to waning global liquidity as growth slows sharply and savings are depleted. Ultimately, countries and asset markets have to compete for liquidity. In the context of loanable funds or investment flows, this competition has put upward pressure on yields, with the US real rate — as reflected in Tips — setting the base.

SA financial markets are already reflecting this competition via the higher Reserve Bank policy rate, as well as elevated government bond yields. With safer assets now being viable, a rally in domestic long-term yields would require a strong catalyst. A US Federal Reserve (Fed) pivot and lower short-term rates could do the trick, but this is unlikely to happen soon.

Alternatively, greater fiscal prudence from the finance ministry or the accelerated implementation of deep reforms could lead to a constructive debt ratio and lower bond issuance. This too seems unlikely, particularly given the political calendar.

Unfortunately, the downside of higher interest rates is that economic growth will be dampened via the cost of credit and the wealth effect, among others. As Reserve Bank governor Lesetja Kganyago recently noted, we have moved from a period of Nice (noninflationary, consistently expansionary) to a period of Vice (volatile, inflationary & contractionary economy).

With the US yield curve now firmly inverted (the short-term rate is above the long-term rate), Mr Bond most certainly agrees that a recession is coming.

• Nel is economist & macro strategist at Matrix Fund Managers.