Why bond investors shouldn't worry about tapering

Charlie Jamieson

Jamieson Coote Bonds

In September we saw bond markets on the back foot a little as concerns around the US debt ceiling arose, and the US Federal Reserve began to taper its accommodative policy settings. 

While the northern hemisphere economies opened up, Australia still wrestled with lockdowns, meaning that our own Reserve Bank are likely far behind their international counterparts. 

Further, we also saw slow-downs in supply chains and inflationary pressures weigh on global markets causing a retreat in both bond and equity markets. 

As we head into the final quarter of 2022 we think there is a lot happening in Washington that investors should be closely watching. 

In this market review, I explore what these inflationary pressures mean for bond yields, why bond markets could reach the top of their fair value, and why investors should not concerned about the market's biggest buyers leaving the market. 

Transcript

Hi, I'm Charlie Jamieson, Chief Investment Officer at Jamieson Coote Bonds and this is a review of markets for September 2021. 

Bond markets were on the back foot a bit in September, coming out a very strong summer Northern Hemisphere performance. 

We often see a big rise in debt capital markets issuance, particularly from corporate issuers through the month of September, but there is obviously optimism that the economies can keep on keeping on, but we do think that the actions in Washington should be the primary focus for investors around a number of different issues. 

The debt ceiling (again)

Firstly, the debt ceiling, we come up against this all the time. Clearly, Democrats have spent a huge amount of money coming out of the pandemic and now they walk on a really fine line to try and get the debt ceiling extended to pay the bills that they've racked up over the course of the last 12 or 18 months.

And they do probably need some Republican help in order to do that. Without being able to extend the debt ceiling, that would cause a technical default or start to shut down the US government. And that is a really, really big deal. 

This is mainly politics, but it's certainly worth watching, and risk markets will really care about this. Republicans are taking a very hard line suggesting they're not responsible for this spending and they shouldn't have to pay the bill or be part of the resolution to make that occur. It's a Democrat issue and it needs to be dealt with by Democrats. 

And at the moment, we're at an impasse between moderate and more conservative Democrats. So that's something definitely to watch. 

The other huge issue is the beginning of the tapering from the US Federal Reserve and motivations around that tapering. 

Recently, we've had two Federal Reserve governors resign after it became public that they had traded in securities that they'd then voted on in terms of enacting very accommodative policy, where clearly they would benefit in their own personal circumstances.

It is just quite extraordinary, really, in this day and age, that seemingly our policy creators could be not subject to the same insider-trading regulations that we all are left collectively in the markets. 

It's forced the resignation of a couple of Fed governors. It's starting to bubble up as a bigger and bigger issue, but we think it can also bring the Federal Reserve Board closer to that taper moment, maybe with less personal investment to keep extending these incredibly generous accommodative settings that we've got. 

Settings that were enacted to deal with the crisis emergency of March and April 2020, clearly in the Northern Hemisphere where people are vaccinated, inoculated, have had COVID, economies have been released, movement is back, COVID is becoming yesterday's story in many respects, sadly here it's very different still currently, but we will have our own release moments soon. 

But these settings don't look right for the economies as we find them today, economies that are broadly bubbling along quite well.

Inflation pressures

Now, inside of that, we've still got quite substantial supply-side disruption and that's starting to cause some inflation pressures. We're seeing that a little bit very acutely in energy markets at the moment. So that's also something that we think bears watching. For a number of reasons, as we're coming into the Northern Hemisphere winter, energy prices are already elevated. 

There are supply shortages and things like in Brexit, post-Brexit, UK, a shortage of truck and lorry drivers to deliver fuel, some very strange, but relatively one-off things occurring. But as a collective, it certainly is bringing some of that inflation conversation back to markets. And that combined with tapering, I think will be an anti-liquidity moment, which can see all assets just leak a little bit. 

And we've kind of seen that over September with both bond and equity markets retreating broadly across the month.

Now, we think that's going to take bond markets to the top of what we believe is their fair value ranges, around 150 in US treasuries. There is of course the chance that we could step a little higher than that. 

But as we saw earlier in the year with the big sell-off of February and March, it's very unlikely to be sustained at high yields, the economies and the debt structures that have been created post the COVID experience just simply don't work very well with higher borrowing yields, and it puts pressure on corporates and consumers. 

So we do think that there'll be an opportunity in that particularly if we are withdrawing liquidity. 

Why holding unhedged international assets could do quite well.

Now ordinarily, you'd think the reduction of liquidity by a taper moment would be quite negative for bond markets taking out what has been their biggest buyer. It will also occur with a material drop in supply as fiscal constraints start to kick in, we're coming into the largest fiscal cliff period as we go into 2022 with a huge reduction in government spending. And so we think that ultimately those things are going to cancel each other out and we will hold a broad range in bond markets. 

As we turn to the domestic economy, the RBA are likely to be a long way behind any of their international counterparts in normalising policy settings and with the Fed starting to get going, and we expect later this year, we think ultimately that can put more pressure on the Australian dollar and it will mean that holding unhedged international assets could do quite well. 

We're seeing some geopolitical flare-ups around places like China and that always bodes well for a stronger US dollar. But certainly, with that ramping up of tapering expectations into the end of the year, no doubt on the day that it's announced, bond markets might move a little bit to the left, but broadly when we start tapering, bond markets tend to do very well. And that's because riskier assets don't tend to like the environment when they're not under full accommodation. And we do see this return to a flight-to-quality environment.

But I do hope you're holding on okay, if you are watching this in Melbourne and Sydney, we're certainly excited to potentially get back into the office and get to a more normalised kind of Christmas period. But yeah, we do think, watch those events in Washington very, very closely. There's a lot going on there and they can really drive market sentiment quite powerfully into the end of the year. Thank you very much.

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Charlie Jamieson
Chief Investment Officer
Jamieson Coote Bonds

Charles is a co-founder of Jamieson Coote Bonds (JCB) and oversees portfolio management of the Australian and Global High Grade Bond and Dynamic Alpha investment strategies. Prior to JCB, Charles forged a career as a seasoned bond investor from...

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