What are your views on interest rate exposure in the current climate?
When thinking about the current environment, it is always important to look back on what has driven interest rates to their current levels and where we can expect them to go from here. Ever since the financial crisis in 2008, central banks have been trying to revive economies by cutting interest rates to historic lows, stimulating affordable borrowing by buying the outstanding debt of sovereign and/or corporate issuers. This approach has been adopted by most of the major developed central banks in the world and has pushed bond yields sharply lower across yield curves. As the major economies have shown initial signs of recovery, investors have started to fear that central banks will withdraw stimulus and drive interest rates sharply higher. The first episode of this occurred in 2013 when the US Federal Reserve (FED) hinted that it would step back from its bond purchase program. This change saw an aggressive re-pricing of interest rate risk with bond yields rising in excess of 1% for ten year maturities. Eventually bond yields fell as other central banks remained accommodative and renewed guidance from the FED that interest rates would only rise gradually.
The most recent episode of an upward correction in interest rates occurred following the presidential election of Trump. Interest rates rose upon expectations of a large fiscal stimulus program which was expected to increase US domestic growth. As the Presidency has evolved, it has become more evident that implementing such policies would be difficult and more time consuming than bond markets priced. These policy overshoots, combined with a moderation in inflationary pressures, has driven bond yields lower over the past few months. Looking back at these episodes show us that the market tends to overshoot with interest rates before it stabilizes and corrects which is why it is important to be nimble. As a firm, we tend to manage interest rate exposure quite actively; we have switched between inflation linked and nominal bond exposure based on the market pricing of inflation compared to our expectations.
Over the longer term we expect interest rates in developed markets to rise only moderately. This is a function of the level of indebtedness of governments, corporations and individuals. If individual borrowers find the borrowing costs on their houses and other rise significantly, this will reduce their discretionary spending and is likely to reduce economic growth levels. With the current level of elevated house prices, it is up to central banks to walk a tightrope controlling excessive borrowing while not pushing the economy into recession as a result of the rising borrowing costs. It is our view that the risks are skewed to the latter so a slow and gradual approach is warranted.
In light of this view, we feel that investors should remain vigilant of interest rate exposure within portfolios, but when market prices deviate from expectations we can find opportunities to take select interest risk.
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