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Interest rates – where do we go from here?

The final quarter of 2016 has undoubtedly been characterised by a marked shift in momentum and investor sentiment within the bond market across different sub-sectors within the asset class.

Many might argue that it has been a long time coming. Let’s face it, bonds, being the more defensive asset classes around, have had their fair share of gains over the past 30-years but signals that this multi decade bond rally could be a some point of inflexion are beginning to emerge, across both sides of the Atlantic.

Let’s start off with the US. Over the past 13-months, between December 2015 and December 2016, we were entertained to two rate hikes by the US Federal Reserve, in the final months of 2015 and 2016.

Data has been robust. Encouraging employment data encouraging, wage growth showed some signs of respite, housing data supported and price pressures (inflation) slowly crept upwards.

GDP and PMI numbers were also positive and the US consumer’s spending patterns were changing. All in all, a concoction which warranted the placement on the lid on the US economy by Fed Chairperson Yellen via two 25 basis points rate hikes.

In the process, we have had the US presidential elections to contend with this quarter. Trump’s victory was one which clearly rattled bond markets.

It is no great secret that Trump's policies are pro-business and investor friendly, which in theory can partially explain the large uptick in yields on long dated bonds in the initial aftermath of the election and in recent weeks (inflation is expected to rise under Trump further strengthening the case of a rise in interest rates by the US Federal Reserve).

What is more important at this stage is the consumption pattern and health of the US consumer which matters most in the initial months of the new legislature, and that is yet to be seen.

Elsewhere in the Eurozone, there was market chatter in October that the European Central Bank might begin to reduce the size of its monthly purchases post expiration of the current accommodative easing program via asset purchases.

Markets interpreted this as optimism that inflationary pressures, despite still being a far cry away from the ECB’s target rate of 2%, could well be on its sustainable upward trajectory.

This saw a marked repricing in sovereign bond yields, particularly the longer-dated ones as the initial reaction was a shift into riskier asset classes. Subsequently, in the December rate setting meeting, ECB’s Draghi confirmed that the program would be extended by an additional nine months and the rate of monthly purchases reduced by €20 billion to €60 billion.

This has continued to exacerbate the shift in risk aversion away from the less risky alternatives to asset classes having higher prospects of returns in the wake of expected improvement in economic data, prompting a pronounced re-pricing in sovereign bond yields.

Primary bond markets were also highly active this year, registering the third largest in terms of amounts issued on record. And this is testament to how bond issuers are taking advantage of the current low interest rate scenario and how they have eagerly and hurriedly issued fresh debt before the possible eventual rise in borrowing rates.

In 2016, issuers have extended their maturity profiles and improved their balance sheets as bonds have been refinanced and rolled-over at significantly lower rates resulting in significant cost savings, but those with upcoming maturities in 2017 and 2018 might not be in a position to take advantage of these levels of interest rates.

The million dollar question now is how to position for 2017. We have been opining for quite a while now that the downside risks within Investment Grade bonds by far outweigh the potential for any upside gains, so the best solution at this stage would be to reduce the overall the duration to bond portfolios, as longer dated bond are more susceptible to adverse movement in interest rates.

Focus on credit risk and the financial health of the companies you are investing, because now more than ever, holding solid names in your portfolios coupled with contained exposure to long dated bonds is the strategy which should pay off going forward.

This article was issued by Mark Vella, Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt .The information, views and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. Calamatta Cuschieri Investment Services Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website. 

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