The two most important prices in the world are, arguably, the price of a barrel of oil and the price of money (represented by short and long term interest rates). Both have a significant impact on current and future growth and inflation, and therefore, are inextricably linked to movements in the price of both bonds and equities.
Since Hurricane Katrina hit the Gulf coast commentators, including us, have been focusing on the impact of supply disruption in oil markets and headlines such as the £1 a litre now being paid in some UK petrol stations – or at least those with updated digital displays on the pumps! As usual, however, rising oil prices are impacting other market variables and there has been a significant shift in interest rate expectations in recent days, particularly in the US.
What US interest rate rises mean for bonds
Despite the fact that the US Federal Reserve has now raised interest rates at 10 straight meetings they still stand at a historically low level of only 3.5%. Rises in the oil price are still being viewed as more of a hindrance to growth than a harbinger of future inflation and so, given the recent events in the US, markets have begun to take the view, once again, that the US Federal Reserve may be close to ending their policy of hiking interest rates.
As usual the market has been fickle and has moved, in the space of a few days, to expect a peak in US rates at 4%. Unsurprisingly, this has corresponded with an improvement in rate expectations elsewhere (the UK market is now pricing in another quarter point cut, to 4.25%, in the first quarter of next year) and a rally in bonds down to levels last seen in 2003 in the UK and to levels not seen for generations in Europe.
Many economists are following the market in suggesting that the Fed will pause from raising rates for the first time in this cycle when the next decision is made on September 20th. The notion of a pause by the Fed runs counter to their recent statements, where they have made clear their intention to carry on pushing rates higher from levels which they still view as accommodative. The market may be right in its assessment, however, if the Fed views the impact of Hurricane Katrina as a net growth negative or concurs with the market that the oil spike will harm growth without proving inflationary.
Why the balance of risks has changed for bonds investors
The market may, ultimately, be proven right in its assessment of the eventual level of UK and US rates and the prospect for a pause in hikes but, for investors, it appears to us that the balance of risks has once again changed. Fixed income markets are again priced for a very low peak in interest rates in the US, and a further cut in the UK, and appear to have little premium for any inflationary pressures.
Even if we agree with this analysis and conclusion, this outturn is already in the price and will not now make us capital returns. With a guaranteed nominal return (before the effects of inflation) of only around 4% in the US, 4.2% in the UK and 3.1% in Germany, over the next ten years, we are bearish on fixed income. In a world of low returns timing investment decisions becomes key. The long run backdrop of low interest rates and muted growth and inflation may well continue to prove supportive for fixed income but, right now, bonds are a sell.
By Paul Niven, Head of Strategy at F&C Asset Management
Recommended further reading:
For more on how Hurricane Katrina, read about the Federal Reserve’s reaction and the effect on the US consumer. Visit our section on investing in bonds for a full list of articles on all aspects of bond investments.