By Ewan McAlpine
Since the first mention, in May 2013, of the possible reduction by the Fed of its quantitative easing (QE) programme of asset purchases, bond yields in the US and other markets (including the UK) have risen to reflect the markets’ expectations in relation to the future path of central bank policy rates.
In December 2013, the Fed finally announced the start of QE tapering, reducing the amount of monthly asset purchases by US$10bn to US$75bn. This is a small move, and a long way from a proper unwinding of QE (e.g. a sell-off of the assets that have been purchased under the QE programme). However, this first small step allows the Fed to consider a further reduction in January and, above all, it is an important one in the long road towards unburdening markets of the weight of QE. It also focuses attention on the possible path of interest rates in the US and in other markets, including the UK. Crucially, the Fed’s tapering announcement was offset by a stronger dovish tone on rates, suggesting that they will remain near zero beyond the point that unemployment falls below the Fed’s 6.5% threshold, set as a parameter in its forward guidance. This reassurance that rates will remain on hold has been enough to allow equity markets to remain positive, and for emerging markets not to react badly.
In the UK, there has been no suggestion of a change to the Bank of England’s Asset Purchase Facility target, which remains at £375bn. However, the Bank of England has acknowledged that the speed at which the unemployment rate has begun to fall would mean that the 7% threshold, as set out in its own forward guidance, is likely to be reached sooner than originally anticipated (in 2015 rather than 2016). For forward guidance to be meaningful, and given how much has been said of the need to keep rates lower for longer in the UK, the unemployment threshold may need to be reviewed. We believe that rates will remain at their current 0.5% level over 2014.
As strong survey and economic data continue to point a positive picture and markets grow more confident of continued and sustainable recovery, government bond yields will continue to rise. We would expect the yield on 10 year gilts to rise moderately from its current 3.00% level beyond 3.25% and approaching 3.50% by the end of 2014. Such a move would produce negative performance from 10 year gilts.
Sterling credit spreads ended the year at the lower end of their 2013 range, although we continue to believe that the pricing of credit bonds undervalues the asset class relative to government securities. We expect small positive absolute returns from investment grade sterling credit bonds in 2014, as the impact of rising underlying government bond yields is offset by credit returns in excess of gilts. On a longer term view, we expect investment grade sterling credit to outperform gilts by at least 1.5% per annum over the next three years.
Ewan McAlpine is senior client portfolio manager at Royal London Asset Management
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