While the past few years have been dominated by central bank interest rate cuts, 2018 has been much more even – with an almost identical number of hikes and cuts.
It is clear the era of ultra-accommodative polices is over. The trend now is for higher global interest rates, with further monetary tightening expected in the second half of the year.
In developed markets, this includes the Federal Reserve, which is expected to deliver two more interest rate increases in 2018. It is also possible the Bank of Canada will hike for the third time this year while the Bank of England has resumed its tightening cycle after taking time to assess the impact of last November’s hike. Sweden, where inflation pressures are rising, has emerged as another potential candidate for raising rates lately.
This overall tightening of financial conditions has had a knock-on effect on emerging markets (EM), where several central banks acted in response to the combination of depreciating currencies and domestic inflation pressure. In June, Mexico, Turkey, India, the Philippines, the Czech Republic and Indonesia all raised interest rates and it is likely more EM countries will follow in the second half of the year.
Opportunities remain despite hiking
While this is a challenging environment for fixed income investors, opportunities can still be found even when central banks are hiking. Romania stands out in this regard, with its central bank hiking interest rates by 75 basis points since January. With further increases already priced in by the market, the country’s five-year domestic bond looks appealing at a current yield of around 5 per cent.
Other countries are at different stages of the interest rate cycle. In Eastern Europe, for example, the Czech Republic kicked off its tightening cycle mid-last year – while Hungary and Poland have been reluctant to follow suit so far despite robust growth and rising inflation.
China was one of the first to raise rates earlier this year, but since then its central bank has shifted toward a softer stance amid signs the economy is slowing. These developments have helped the Shibor, the Shanghai interbank offered rate, come down by almost 1 per cent from its January highs. The combination of softer inflation and infrastructure deceleration should be supportive for local Chinese bonds in the second half of this year.
Alert to overheating in credit
Signs of overheating in credit markets are also apparent. M&A activity has been picking up again and 2018 looks set to be a record year in the US for takeovers. This has occurred at a time when fears of an overhang from issuance and excessive valuations have weighed on prices in investment-grade corporate bonds. Investor appetite for corporate bonds has clearly waned lately, as shown by the concessions given on new issues.
More surprising has been the underperformance of A-rated bonds versus BBB-rated securities this year, which has created opportunities to rotate into higher-quality names at more attractive premiums. There may also be an opportunity to switch some credit risk out of corporate bonds into agency mortgages, where signs of overheating have been far more subdued.
Although home prices in the US have steadily outpaced income growth for the past two years, the situation remains relatively healthy, with data indicating that the average household debt service ratio is at its lowest since the financial crisis. The shape of the interest rate swap curve makes owning a combination of agency mortgages with higher coupons and lower durations a very attractive proposition. offering better risk/reward compared to investment grade corporate bonds.
Arif Husain is portfolio manager of the T. Rowe Price Dynamic Global Bond fund. The views expressed above are his own and should not be taken as investment advice.