An impending central bank “regime change” in response to a break-down in established economic models “is not going to be great news for bond investors”, according to Jim Leaviss (pictured), manager of the M&G Global Macro Bond fund
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Leaviss has been expecting a major shift in central bank policy for a number of years now and, while this has yet to happen, he said there are signs that the Federal Reserve’s Chicago conference in June may be the starting point for a change in direction.
The manager said there will be a great deal of scrutiny in particular on the aim of keeping inflation low.
“I think they are flagging that they are going to do something,” he added.
“Not something radical. They are going to stick to an inflation target – they know they have got these mandatory statutory targets – but maybe the timescale for hitting 2 per cent inflation will be a long-term average, maybe they target nominal GDP, so GDP plus inflation.
“Certainly something that allows them to keep the economy running hot. They worry that this is a fragile economy.”
Leaviss said the Fed and other central banks are right to worry about causing a recession if they hike interest rates much further at this stage of the cycle.
The manager pointed out that with debt in the global system now much higher than it was before the financial crisis, it wouldn’t take much to put the average UK mortgage owner into severe financial difficulties, for example.
“People have got used to very low levels of rates,” he continued.
“They have levered up, taken on too much debt, that is true of individuals, companies and governments and so the Fed is absolutely right to be nervous about getting it wrong and about hiking rates too much. I think it probably saw already the rate hiking cycle has already had enough of an impact to start slowing the global economy.
“The global economy going into Q4 last year and certainly going into this year has probably underperformed people’s expectations.”
**Source: M&G/JP Morgan Research, 4 January 2019
Fear of causing a recession is not the only reason why the Federal Reserve may be losing its enthusiasm for further rate-hikes. US president Donald Trump previously described the central bank as “a bigger problem than China” and, at the Conservative Political Action Conference on 2 March, disparagingly referred to chairman Jerome Powell by saying: “We have a gentleman that likes raising interest rates in the Fed. We have a gentleman that loves quantitative tightening in the Fed. We have a gentleman that likes a very strong dollar in the Fed.”
*Source: M&G Morgan Stanley Research, 3 January 2019
Leaviss said this type of interference is likely to become more common in the current political environment.
“You know, in a populist world, politicians take control of central banks, whether it is Erdogan of Turkey or Trump sacking Janet Yellen,” the manager added.
“I would expect more of this, more of the drift away from the post-Paul Volcker years of strict inflation targeting, the strict Eddie George regime, the strict ECB regime, and to something a bit more flexible and a bit more tolerant of inflation going forwards.
“Obviously as a bond investor that is not necessarily going to be great news, as it may mean you want to own a bit of inflation protection in your portfolio.”
It is not all bad news for bond investors, however. One of the reasons why the Federal Reserve is now less concerned about using interest rates to keep inflation under control is because inflation has been hard to come by over the past decade.
M&G Episode Growth manager Eric Lonergan said what he finds most curious is why it has taken so long for the Federal Reserve to realise it doesn’t have an inflation problem. Many of the factors that were expected to cause a spike in this measure in the post-financial crisis era, such as oil moving to $150 a barrel and a tripling of its monetary base, have had a minimal impact.
And, in an era where central banks are losing their enthusiasm for rate hikes, this has led economists such as former IMF chief economist Olivier Blanchard to claim that public debt has no fiscal cost.
“In other words, if the rate of interest at which you issue this great number of government bonds is below your nominal growth rate in your economy then you can issue away,” Leaviss continued.
“What’s the constraint? You can effectively issue as much debt as you like and you are not really going to impact your debt-to-GDP ratio by doing that as long as your interest rate is below the rate of growth. And this is another thing that is growing in popularity among populations that have had enough of austerity.
“Each day the US debt clock near Times Square ticks higher and higher. Well there are bits of the world, for instance Germany, there is a debt clock in Berlin which goes down every single day. They have no deficit in Germany and a decreasing national debt as well. And you could argue in this kind of economy, especially with the fragilities in Europe, that is not a sensible thing to happen.”
With US 10-year interest rates at 2.75 per cent compared with 4 per cent nominal growth, and figures of 1.2 per cent versus 3 per cent in the EU and 0 per cent versus 1.4 per cent in Japan, Leaviss agreed there is plenty of room for growth in debt assuming everything else stays the same.
However, he said that while this is all very well at the moment, ageing demographics mean debt-to-GDP in the US is already expected to move from 100 to 160 over the next 30 or so years and certain studies suggest that for every 1 per cent increase in debt to GDP, there is a 2 to 3 basis point increase in government bond yields.
“In which case by the time we get to 2044 or whatever, then actually interest rates are going to be greater than the growth rate and that’s when it really spirals out of control,” the manager added.
“So long term I am nervous and short term I kind of agree that central banks can’t do a lot about the cycle at this stage and it will be down to politicians to do something. Either way, you could make a fairly bearish case for government bonds under those scenarios.”
Data from FE Analytics shows the M&G Global Macro Bond fund has made 72.08 per cent over the past decade compared with 63.48 per cent from the IA Global Bonds sector.
Performance of fund vs sector over 10yrs
Source: FE Analytics
The $1.2bn fund is yielding 3.02 per cent and has ongoing charges of 0.82 per cent.