Bond markets ‘grappling’ with reflation risks: FSI

Reflation issues between bond markets and central banks will likely continue through the rest of 2021, as the scope and sustainability of the recovery unfolds, according to First Sentier Investors (FSI).

Tony Togher, FSI head of fixed income, short term investments and global credit, said investors were grappling with rising inflation expectations and the idea that centrals would likely let economies run a bit hot before contemplating tightening monetary policy.

“To throw fuel on the fire, fiscal stimulus around the world continues to flow freely,” Togher said.

“In the US, the third stimulus package in a year, slated at US$1.9 trillion, is likely to pass through the budget process in coming weeks.”

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At the same time, the Australian cash market AusBond Bank Bill Index recorded its first ever negative return month in February, an outcome that Togher's team had flagged as a possibility in mid-2020.

“This was due to the extremely low starting running yield of bank bills of [around] one basis point (per annum), combined with a rise in short-end three-month bank bill yields, which tripled to three basis points at the end of the month,” Togher said.

“Just like any other debt instrument, when interest rates go down, the price goes up, and when interest rates go up, the price goes down.”

By the end of December 2020, Australia had recorded two consecutive quarters of more than 3% economic growth and Togher said such momentum created challenges for central banks.

“If inflation increases meaningfully, there could be increasing pressure on central bank officials to review policy settings,” Togher said.

“For now, the banks’ commentary suggests that their current accommodative settings will persist for the next two or three years in most of the developed world.

“Some central banks are even employing yield curve control, targeting specific yields on short-dated government bonds.”

The FSI cash and fixed income team did not expect inflation to spike sharply.

“While things are developing quickly, in general we believe that the bond market’s recent moves reflect improved fundamentals rather than anything nefarious, or an out-of-control inflation spiral,” Togher said.

“Longer-term value needs to return to bonds to make them attractive and useful as diversifiers.

“We are actually getting to the point where bond yields are higher than equity market yields in the US, which should boost demand for high quality fixed income at these levels.

“That said, some distortions are set to remain in the market for a while which makes it a particularly fruitful environment for active managers who can take both long and short positions tactically.”