Read in 4 mins 51 viewed
For fixed income investors, 2018 will be remembered as the year that the 36-year bull run in the bond market looked to have finally come to an end.
Bond prices have climbed since former US Federal Reserve (Fed) Chairman Paul Volcker aggressively raised interest rates in the early 1980s to contain rampant inflation. By October 2018, that rally had started to look precarious as US Treasury yields ticked higher.
Financial markets looked to be finally waking up to the fact that the years of easy money in the form of quantitative easing (QE) was been wound up. In fact, November marked the first time that globally QE went net negative since the global financial crisis.
MORE RATE HIKES…
Even so, we believe the Fed will continue to raise interest rates well into 2019. For the past two years, US policymakers have sought to stop the world’s largest economy from overheating. Despite their action, tighter monetary policy has remained elusive with financial conditions in the US actually easing.
Economic growth remains strong, interest rates too accommodative and leverage has slowly started to build up again in the system. It’s for this reason that we think the market should be prepared for the prospect of the Fed fund rates potentially climbing above 3%.
… AND HIGHER BOND YIELDS
This also means bond yields will continue to rise as the central bank attempts to get ahead of the curve. Of course, US monetary policy is only one driver of yields. The other is something called the term premium, that is the extra return (or yield) that investors should get for holding a longer-term bond rather than a series of short-dated instruments.
RETURN OF THE TERM PREMIUM
While the term premium has historically always been positive, it’s been in negative territory for the best part of two years, pushed lower by QE in Europe and Japan. In 2019, we think it should start to normalise once again, thanks to some big structural changes in the market:
LAST BUT NOT LEAST
Volatility. Investors can expect more of this in 2019 as the term premium continues to normalise. In 2018, any upticks in the term premium precipitated a bout of volatility in other asset classes, most notably in the US equity market which sold off heavily in October.
So in this more normalised (albeit volatile) environment, absolute return funds are, in my view, in a better position to outperform long-only funds. Fund managers who have the ability to invest anywhere and go long or short will be best placed to take advantage of the investment opportunities as they arise.