A final chorus for bond markets?

It was only a question of time before fixed income markets started to react to the currency volatility seen over the last year.

During the most recent quarter, it was bond markets making an about turn on their downward trajectory.

Benign markets

Since the implementation of quantitative easing by major central banks, global bond markets have been somewhat benign in nature. Term premiums on long dated bonds were pushed into low to negative territory.

Bond term premium is the additional yield an investor requires for holding bonds to compensate for the term risk associated with the instrument’s duration. This became so severe at one stage in the early part of the year that even Federal Bank Chairperson, Janet Yellen made a comment about how low term premiums in bonds have been across developed markets.

European all-time lows

This situation was most visible in the European bond market where German ten-year bond yields traded to an all-time low of only five basis points. Investors had no margin of safety to protect them at that stage against an adverse move in market interest rates, as term premiums were negative.

Consequently, this quarter we have seen the extreme situation on negative term premiums reverse in bonds to more normalised levels. The rise in bond yields during the second quarter of 2015 had all to do with the mean reversion of term premiums, rather than a material change in the outlook for growth or inflation.

Central Banks discomfort

Globally, inflation and growth remain at levels below where Central Banks would fear an inflation episode and have to start adjusting monetary policy. So far in 2015, we have witnessed 37 Central Banks across the globe ease monetary policy further.

So it is still clear that Central Banks are not in a comfortable position yet to retract accommodative policy. We know the Central Banks of Europe and Japan continue with their various quantitative easing programs, but it was the Central Bank of China (PBOC) that eased monetary policy the most during the second quarter. The PBOC has been easing policy not just through the reduction in interest rates, but also through bank capital requirements. This signals concern about domestic economic fundamentals, which has had a spill-over effect on commodity producers like South Africa.

SARB hawkish

Locally, the fundamental drivers for growth have been revised lower and the outlook for inflation remains to the upside. The South African Reserve Bank (SARB) Monetary Policy Committee (MPC) revised their outlook for inflation over the next two years substantially higher due to the effects from electricity tariffs, wage increases, food and fuel prices rising at rates well above the upper band of the inflation target.

The MPC has on the back of this turned more hawkish, warning the market of the continuation of the interest rate hiking cycle. This is prudent from the SARB as their credibility is being tested in the face of a higher inflation profile over the next year to 18-months. The fact, however, remains that domestic growth is well below long-term potential growth rates due to various structural reasons.

Moving on up

The expected path of inflation and interest rates is upward, both in the US and domestically. Should interest rate increases surprise on the upside, it will be good for investors holding cash and less so for investors holding long-duration fixed coupon bonds where the yield curve remains very flat.

We remain confident that the cash instruments that we hold are providing our investors with attractive real returns and that those bonds that we hold have been acquired at a yield that has a margin of safety and, if rates do rise substantially, will present our investors with a very low risk of capital loss.