By Ewan McAlpine
As investors plan for the eventual arrival of tapering, some commentators have suggested that the short end of the yield curve might actually be the most vulnerable to volatility as expectations of when and how quickly tapering starts become more and more volatile themselves, whereas the medium and longer-dated parts of the yield curve are already flatter and closer to ‘normal’.
Medium and longer-dated parts of the UK government yield curve have indeed moved higher. A great deal of re-pricing has taken place since the first mentions, in May this year, of the possibility of the Fed tapering its QE programme, and on the basis of medium term expectations for short term rates. While tapering and rate rises used by central banks are different tools, they are linked by the expectations of and impacts on growth and inflation in the economy. The re-pricing of gilts has been particularly apparent in relation to medium-dated bonds. These had already become expensive, having been seen as a safe-haven asset during the extended period of the eurozone sovereign debt crisis. Once this source of demand for gilts had begun to wane, the combination of improving survey and economic data in the UK and increasing talk of tapering in the US, both of which would suggest a rise in interest rates at some point, pushed 10-year yields sharply higher, from 1.6% in May to as high as 3.0% in September.
Notably, the increase in medium and longer term gilt yields has taken place without an actual start to tapering, let alone a base rate increase. While medium and longer term bond yields are free to be driven by medium-term expectations for base rates and medium and longer-term expectations for growth and inflation, the front end of the curve is closely anchored to base rates and cannot move without a change in near term expectations for base rates themselves. However, at the point where tapering is about to begin, there is likely to be far more speculation in relation to the path of base rates, and volatility in short rates. Once tapering does start, and even once a rate hike does take place, unless there is a clearly marked out path for base rates (which even forward guidance cannot be expected to provide), volatility in short rates will remain high. It is possible that this volatility will be higher than in longer term yields.
In moving higher, yields have moved closer to what might be considered ‘normal’ levels. But if one were to consider normal levels for 10 year gilt yields to be 5% (on the basis of 2.5% long-term growth expectations and 2.5% long-term inflation expectations), we are clearly still some way away.
In our view, it will take some time to reach these levels; our 10-year gilt yield forecast for the end of 2014 is only 3.0%, versus its current level of 2.8%. In addition, a number of sources of risk remain, including structural problems in Europe, the ongoing issues regarding the debt ceiling in the US, to be revisited in February 2014, and the strength of the economy in China. These sources of risk present the likelihood that the progress of medium and longer term yields, towards their end of 2014 levels and beyond, is likely to be volatile.
In conclusion, volatility all across the yield curve is likely, as much at the short end as the long end. However, a crucial point to remember is that, factoring in duration, the impact of uniform levels of volatility across the curve on capital value is much greater for longer term bonds. Considerations of positioning on the curve become more than only in relation to the ultimate direction of rates and yields.
Ewan McAlpine is senior client portfolio manager, Royal London Asset Management
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