LISTEN: Over the past three years, the bond market has been battered by economic headwinds. But have we reached the bottom of the cycle? Annelise Peers, Chief Investment Officer for Investec Bank Switzerland and Awongiwe Booi Fixed Income Analyst at Investec Wealth & Investment SA explain.
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Investors in the fixed income market, have had a tough time over the past three years. Low economic growth, persistent inflation, wavering investor confidence, and high interest rates have collectively battered the bond market.
A recent surge in the 10-year Treasury yield to 5%, a level not seen since 2007, has sparked widespread panic and a sell-off of US government bonds. But does this mark the bottom of the cycle, or is there more turbulence ahead? And what lies ahead? That informed a key discussion on the fortnightly Investec Focus Radio podcast No Ordinary Wednesday with Annelise Peers, Chief Investment Officer at Investec Bank Switzerland, and Awongiwe Booi, Fixed Income Analyst at Investec Wealth & Investment SA.
Increased bond market outflows
The rapid increase in the 10-year Treasury yield has had significant global implications, as it increases the cost of borrowing for the US government. This, in turn, affects economies and investors worldwide. “Because inflation picked up, nobody wanted to lend money to the American government, for example, at 0 percent anymore, so the price went up. We're charging the American government 5 percent now to borrow in the 10-year area, and that has had this big impact that has led to the bear market in the bonds. And that is why you've had such a big outflow in bond markets across the world,” says Peers.
The situation is not isolated to the US either; other countries, such as the UK, have experienced substantial outflows from fixed income funds, indicating a broader trend of concern and uncertainty in the market.
Peers says the bear market in bonds is a direct consequence of the changing economic landscape post-Covid-19. With inflation rising sharply and growth picking up due to various stimulus packages and geopolitical events, the cost of borrowing has increased significantly. Investors are now seeking refuge in equities, perceived as an inflation hedge, leading to substantial outflows from bond markets globally. So, if you grow well and inflation abates or remains stable, that's when equities do well. “It is only when inflation gets out of control that equities and bonds don't do well,” says Peers.
Bond market investors in a state of uncertainty
Despite inflation peaking and moving closer to the Fed target range, central banks remain cautious, maintaining higher interest rates. This cautious stance has left bond market investors in a state of uncertainty. Peers believes there is a disconnect between bond investors, who traditionally focus on inflation, and investors in risk assets, who are currently fixated on growth prospects.
Traditionally the bond market looks at inflation, but they're now saying yes inflation is around 3%, the Fed target is 2%. It is due to slow to 2%, but if growth remains this strong, inflation might pick up again. And that is what has caused this disconnect with bond investors and risk assets, because risk assets are looking at growth at the moment.
Headwinds unsettle fixed income and credit market in SA
On the impact on South Africa, Booi says structural issues, a sluggish economy, and monetary policy constraints are among the factors contributing to the precarious state of the country’s s fixed income and credit market. “I think those factors really do contribute a lot to where we are seeing yields, both in the credit market – and when I talk about the credit market, I see that as cash and your normal banking bonds – and our 10-year bonds. And what we're basically seeing there is that there's definitely risk from the fact that there's monetary issues, but also there's a risk from an issuance perspective,” says Booi.
Booi also notes the surge in interest from the local market in government bonds, driven by attractive yields, despite the inherent risks. “If you look at where yields were about 10-15 years ago, yields were sitting around 6% to 7% and now we're seeing yields north of 11%. So the market definitely is chasing more yield. And as a result of that, we've seen more local residents holding more (local) bonds than offshore. We've seen a lot of sell-off from offshore,” says Booi.
Sovereign debt worries for the bond market
Both Peers and Booi underscore the pressing concern of escalating government debt globally and in South Africa. The rapid increase in interest rates, coupled with high sovereign debt levels, poses a significant risk to the bond market and the broader economy. The need for strategic debt issuance and management is more crucial than ever. “The other worrying thing is the interest repayments from the US government, for example. They have to issue more debt and their spending on interest payments will very soon be one of the biggest parts of their spending. At the same time, their tax revenue has also dropped because of financial markets. So capital gains tax in America has dropped away and as result their revenue has dropped sharply away,” says Peers.
She adds, “And if you were to have higher inflation or growth being too high, it means that interest rates stay higher for longer, which will lead to a lot of pain, I think, across the world because we are seeing a strong dollar, while oil prices have picked up and interest rates are high. The growth tax that is basically created by those three factors, it's getting to dangerous levels for growth.”
Booi points to the debt on the South African government balance sheet and the widening fiscal deficit. “Looking at the fact that when the government is issuing bonds, they're issuing them at higher than ever interest rate levels. Previously we were issuing at lower levels or lower interest rate levels, and now it's higher than it has been for a long time. So that puts another spanner in the works in terms of how the National Treasury balance sheet is going to look like. So I think the market is very much concerned, not so much in the short term, more in the long term.”
On the currency front, Peers and Booi say predicting movements over a short period, like six months, is always a challenging task, laden with uncertainties and influenced by numerous global and local factors. When it comes to emerging market currencies, such as the South African rand, the task becomes even more complex due to their inherent volatility and sensitivity to external shocks.
The rand, like other emerging market currencies, is influenced by a range of factors including commodity prices, domestic political stability, global risk sentiment, and monetary policy differentials between South Africa and the rest of the world, particularly the United States. “Local (South African) weak fundamentals will continue and they're not short term issues that we have, they are prolonged long term issues that we have within the South African context that still need to be rectified,” says Booi.
Recently, we have seen that when the US Federal Reserve hikes interest rates, it creates a challenging environment for emerging market currencies. Investors tend to move their capital towards safer, lower-yielding assets, often leading to a sell-off in emerging market currencies. In the South African context, the rand has shown resilience at times, supported by high commodity prices, given that South Africa is a significant exporter of precious metals and minerals. However, domestic challenges such as energy supply constraints, logistical issues, and fiscal imbalances continue to pose significant risks and add to the currency's volatility.
Peers and Booi say the fixed income market at present is navigating turbulent waters, grappling with the aftermath of unprecedented global events and policy decisions. While challenges abound, there are also opportunities for strategic investors to navigate the complexities of the current financial landscape.
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