Brexit is a Game Changer for Bond Investors, says JP Morgan

Central bank policy is divided - but there are profits to be made in fixed income if you can stay one step ahead of the Fed, ECB and Bank of Japan says JP Morgan

Emma Wall 27 July, 2016 | 10:41AM
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Emma Wall: Hello, and welcome to the Morningstar series, "Why Should I Invest With You?" I'm Emma Wall and I'm joined today by Bob Michele, Head of Global Fixed Income for J.P. Morgan.

Hi, Bob.

Bob Michele: Hello Emma.

Wall: So, we're here today to talk about fixed income and the thing hanging over the entire market is the Fed. So, when do you at J.P. Morgan expect the Fed to raise rates?

Michele: Well, there's no doubt the Fed does want to what they call ‘normalise interest rates’, which is code for raising the Fed funds rate. They are trying to do it as passively as they can so they don't disrupt the markets, they don't tighten financial conditions accidently and more so, so that the rest of the world has a chance to heal and recover. So, I do expect them to try and get one more rate increase in before the end of the year.

That would move the Fed funds band up to 0.5%, 0.75%. If the global economy and the U.S. economy look a bit firmer than they do today, I think they could do two before year end. I think that puts the Fed funds target rate neatly at that 0.75% to 1% band and I think it achieves what they really want to achieve, which is, to put some air into the front end of the yield market and stop penalising savers.

Wall: And at the beginning of the year we'd have said that the U.K. was in the same basket as the U.S. looking to raise rates this year, but of course we've had the Brexit vote, which means the U.S. seems to be on its own with its policy it's taking, raising rates, and the rest of the world is lowering them. How does that affect fixed income investors?

Michele: Well, that's very true that Brexit I think has been a real game changer and if you go back to the start of the year, the Fed's playbook would have been to raise rates at least four times this year and I think to do one maybe two is much, much less than they would have anticipated. So they are trying to build in the uncertainty of what Brexit will bring and the fact that Article 50 hasn't been triggered yet and likely won't be triggered until January just lengthens that degree of uncertainty.

I think what it means for the bond markets is that people can expect yields to stay lower for longer. So, that's not going away. I think the U.S. bond market will play the game of guesstimating where the terminal Fed funds rate will be, will they get to 1%, will they get to those mythical dots at 3.25% and what typically happens when the Fed raises rates is the yield curve tends to flatten out around the terminal rate. So, if they get to 1%, I think you could expect yields in the two-year all the way out to the 30-year to be within touching distance of 1% and that's our expectation.

Wall: Of course, that means it is difficult for you to find value within the bond market. Where are you seeing those greatest opportunities?

Michele: Well, I always like to think that in a market where central banks are printing money – you have the Bank of Japan, you have the European Central Bank, together they are printing close to $0.5 trillion every three months. That's a lot of money. And people forget, it just doesn't sit on balance sheets. It actually goes right into the bond market. So, it backstops a lot of things that they are buying.

So, I like to think in this market we should for yield because so much of the world's bond market has negative yields. If I look at the 10-year treasury, which today is about 1.6%, over 85% of the world's government bond markets yield less than 10-year treasury. So that's already a lot of yield. And I think you want to buy the kinds of things that the central banks are buying in one degree of separation.

So, if the European Central Bank is buying European governments and European corporate bonds, a lot of the holders of those securities will sell them to the ECB and they will export that money to the U.S. and they will buy U.S. investment-grade corporates, they will buy U.S. agency mortgages, they will buy European high-yield. You're seeing the same dynamic in Japan where the holders of JGBs are selling them to the Bank of Japan, they are buying U.S. securities, they are buying Australian government bonds. So, I think a blend of government bonds and credit if you have reasonable return expectations are a pretty good place to be for the foreseeable future.

Wall: Bob, thank you very much.

Michele: Thank you for inviting me.

Wall: This is Emma Wall for Morningstar. Thank you for watching.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Emma Wall  is former Senior International Editor for Morningstar