Active Thinking

At GAM Investments’ latest Active Thinking forum, David Dowsett discussed the ongoing bond market crash and why he believes markets are losing trust in policymakers.

27 September 2022

David Dowsett, Global Head of Investments

It is impossible to exaggerate the extent of the moves we are currently seeing at the short end of interest rate curves. The two-year treasury, which is the liquid, essentially risk-free asset from which all other investment returns are benchmarked, was trading at 20 basis points (bps) 12 months ago. Today, it trades at 4.3%, which follows an 80 bps move higher during the course of September alone. It is difficult to predict what will happen next but importantly, until that rate stabilises, no other market can go up. Everything from the dividend yield on an equity investment to the yield on a fixed income instrument to a property purchase must be compared to the return on the risk-free rate. So as that rises every day, prospective returns on all other assets must be recalibrated.

During the last week, we have seen an intense period of interest rate hikes, with the [Swedish] Riksbank raising rates by 100 bps, the Federal Reserve (Fed) by 75 bps, the European Central Bank by 75 bps and the Bank of England (BoE) by 50 bps. Only the Bank of Japan did not join the movement, but that in itself is manifesting as stress in Japan, weakening the currency and leading policymakers to intervene. It seems that the market cannot call the top of the interest rate hike, partly because it is losing trust in policymakers, which I explore further below.

Last week’s meeting revealed that the Fed is forecasting interest rate hikes and higher interest rates will be prolonged, specifically averaging 4.6% for 2023 and 3.9% for 2024. Investors are increasingly coming to the conclusion that interest rates have moved into a definitively different environment to that which has been in place since the Global Financial Crisis (GFC) when, aside from short-lived interest rate hikes, the US has essentially had a 14-year period of zero interest rates. Arguably, we are moving into a far more normalised interest rate environment, but this is nonetheless a very painful transition.

Somewhat manifest in the market reaction we are currently seeing in the US is investors’ shifting beliefs regarding whether the Fed can engineer a soft landing. For a period, the market believed this, but there is a gradual realisation that the window for a soft landing has closed and as a result, equity markets are falling on the back of rate hikes and Fed rhetoric.

We have seen dramatic moves in UK markets in recent days following Chancellor Kwasi Kwarteng’s mini budget, in which he announced a series of unfunded tax cuts on the back of an energy bailout. Arguably, this in itself does not destabilise debt dynamics for the UK but the government has appeared cavalier in its approach in recent months and this policy also seems to set the government against the BoE. This has led sterling to plummet. Further, there is a sense that the government’s policy is not well planned and this has had an instant impact on assets, particularly at the short end of the gilt curve. On Friday, five-year gilts moved more than 50 bps, the second largest move ever, followed by a further 50 bps rise on Monday morning. Speculation about an intra-meeting hike from the BoE is also growing as the economic competence of the UK government seems to be being called into question.

As challenging as the current market environment is, it is arguably a trade that had to happen as we move into a period of interest rate normalisation and out of emergency interest rate policy. We believe this is an environment where, when we get there, assets will not all move in synchronicity as they have done of late. Rather, it will be one where good credit analysis, careful stock picking and deep analysis of the monetary policy cycle will be the way to deliver for clients. It feels difficult in the short term but we believe it is an environment to embrace in the medium term.