Interest rates around the world remain ultra-low, fiscal stimulus in many countries may be near a peak and major economies’ monetary policy will likely become less accommodative. We asked Capital Group global bond manager Andrew Cormack how he is investing in these markets. Five key themes emerged.

1. US Treasuries: Biased in favour of a yield curve flattener

At its June meeting, the US Federal Reserve gave us a clear signal that it will become less accommodative. It makes me less constructive on the short end of the Treasury yield curve. But it also reduces the likelihood of an inflation spiral, which is why we saw Treasury yields come down in July and August. That probably reduces term premiums and provides support for long-term rates, which leaves me with a bias for a flatter yield curve over the medium term. Treasuries also continue to be supported by the interest rate differential to other developed markets such as Europe and Japan, where yields remain negative across much of the yield curve. We continue to see strong demand for Treasuries from pension funds and foreign buyers.

Fed policy influences not just the US, but the global economy and markets. The Fed in my mind is essentially the global central bank, since it prints the global reserve currency. Fed policy is exported globally through many financial channels. Since June, the Fed has become more attentive to inflation; it has tempered inflation fears, which in turn has alleviated pressure to tighten policy on other central banks, such as the Bank of Canada, the Norges Bank and even the European Central Bank (ECB). And bond yields have declined around the world.

Treasuries benefit from interest rate differentials and sustained investor demand¹

2. European sovereign debt can provide value despite negative yields

As a global bond investor, I can invest in any part of the world. I don’t totally agree with European policy and market rates staying this low for this long. Negative rates have hampered the banking system, and in turn, the robust flow of credit into European economies. Does that mean I avoid negative-yielding bonds in Europe? The answer is no, because I don't have to hold those bonds to maturity.

If the funding rate is ‒0.5% and I can buy a negative-yielding short-maturity bond for ‒0.1%, then that bond is going to have what we call a positive roll-down. So, it can still generate a positive capital gain as long as I am careful about selling at the right time. And fortunately, there's a large, price-agnostic buyer in the market: the ECB. Through its quantitative easing program, the ECB has facilitated this opportunity in European bond markets. That said, with yields having come down in most markets since the start of the COVID-19 pandemic, these bonds have become less profitable as an investment as yield curves have flattened.

Looking at the non-core markets in Europe, I am more cautious. As inflation comes closer to its target, the ECB probably needs to start tapering the Pandemic Emergency Purchase Program (PEPP). If that starts to push European yields higher, some countries that have benefited from the PEPP may struggle to finance their debts. For example, Italy’s gross debt stands at about 150% of gross domestic product. That level of debt is only sustainable for Italy if yields remain very low. It's probably not something to worry about over the next six to 12 months, but it’s something I am closely monitoring.

 

1.Source: Bloomberg. As of 31 July 2021. Dotted lines are market expectations.

 

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