Volatility Poised to Increase After Quiet 2017December 19, 2017
- Although markets have thus far shrugged off risks, including North Korean nuclear tests as well as expected actions by many developed market central banks to unwind their ultra-accommodative monetary policies, we think that is unlikely to persist through 2018.
- The potential risks that could shake up fixed income markets include a surprise in developed market politics, a breakdown in the NAFTA negotiations, escalating geopolitical tensions, and an abrupt slowdown in the Chinese economy.
- With some major developed market central banks beginning to scale back their extremely accommodative monetary policies, there is the potential for increased volatility if markets misjudge the speed or timing of the normalization process.
- Maintaining meaningful allocations to liquid sectors allows us tactical flexibility should volatility create pricing dislocations and more favorable valuations in credit sectors.
Although volatility across fixed income sectors has been remarkably low this year, a variety of risk factors lead us to believe that volatility will increase in 2018. Markets have thus far shrugged off risks, including North Korean nuclear tests as well as expected actions by many developed market central banks to unwind their ultra-accommodative monetary policies, but we think that is unlikely to persist through next year. As a result, we favor meaningful allocations to liquid sectors such as high-quality developed market sovereign debt to facilitate tactical portfolio shifts in response to a risk event.
STEADY GROWTH, SUBDUED INFLATION
In the second half of 2017, the global economy showed strong growth and continued subdued, though moderating, inflation. Despite geopolitical and economic risks, volatility remained low, with global developed market government debt trading in a relatively narrow range for much of the year.
In 2017 through late November, the yield on the 10-year U.S. Treasury note generally stayed between 2.10% and 2.60%, atight 50 basis point (bp) range. This was in contrast with 2016, when the range was 115 bp (from 1.40% to 2.55%). The 10-year bund yield has largely traded between 0.20% and 0.60% this year, with the 40 bp range contrasting with last year’s 75 bp range from -0.15% to 0.60%. The Bank of Japan (BoJ) in 2017 targeted a 0% yield on the 10-year Japanese government bond, keeping yields generally within a 10 bp range this year versus last year’s 55 bp range (-0.30% to 0.25%). Low rate volatility has been a consistent theme across developed markets in 2017.
In credit sectors, the lack of market volatility and strong equity markets helped credit spreads grind steadily tighter through much of 2017. European high yield spreads compressed so much that the yield in the sector, as measured by the J.P. Morgan European Currency High Yield Index, reached 3.00% at the end of October compared with an average yield since 1999 of 8.78%. Credit spreads on U.S. high yield bonds and U.S. investment-grade corporate debt reached their narrowest levels in 10 years late in 2017. Although spreads widened somewhat in November, money subsequently flowed back into both high yield and investment-grade credit to take advantage of the widening, supporting the sectors.
RANGE OF RISKS THAT COULD ESCALATE
There are several potential risks that could shake up global fixed income markets. A surprise in developed market politics, such as a failure to enact tax reform legislation in the U.S., tumultuous Brexit negotiations between the UK and the European Union, or a renewed move toward Catalonian succession from Spain, could trigger more volatility in credit sectors, as could a breakdown in the North American Free Trade Agreement (NAFTA). Of course, geopolitical risks on the Korean Peninsula and in the Middle East could re-escalate, with conflict in the Middle East likely impacting oil prices. Also, while we still anticipate that China will be able to manage its transition to an economy focused on domestic consumption rather than exports, an abrupt Chinese slowdown would impact global markets through a variety of channels.
DEVELOPED MARKET MONETARY POLICY NORMALIZATION
With some major developed market central banks beginning to scale back their extremely accommodative monetary policies, there is the potential for increased volatility if markets misjudge the speed or timing of the normalization process. Although we anticipate that the Federal Reserve will continue to gradually raise rates as it slows reinvestment in its bond holdings, a faster-than-expected pace of tightening, which is plausible, would likely jolt markets.
Similarly, although the European Central Bank (ECB) has committed to buying bonds at least through September 2018 while slowing the pace of its purchases, a more abrupt slowdown, though unlikely, would create volatility, should it occur. Although it seems a low probability that the BoJ will be able to ease back on its quantitative easing in 2018, given Japan’s persistently low inflation, a sudden bounce in inflation expectations or changes in BoJ yield curve control would accelerate an eventual move toward tapering.
FOCUS ON DEVELOPED MARKET SOVEREIGNS, EMERGING MARKET LOCAL DEBT
In the current environment of elevated valuations across nearly all fixed income sectors, we have maintained sizable allocations to liquid high-quality segments, including developed market government bonds and agency mortgage-backed securities. We also favor locally denominated emerging market debt, which can offer the opportunity to benefit from monetary easing in countries such as Brazil that are lowering rates, as well as exposure to some emerging market currencies that appear poised to gain against the U.S. dollar.
Maintaining liquidity allows us tactical flexibility should volatility create pricing dislocations and more favorable valuations in credit sectors. While holding liquidity entails a cost, that cost is currently low given tight credit spreads. Although the timing and magnitude of risk events are difficult to predict, history shows that the value of liquidity can increase dramatically around heightened volatility.
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This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.
The views contained herein are those of the authors as of December 2017 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.
This information is not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision.
Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.
Past performance cannot guarantee future results. All investments are subject to market risk, including the possible loss of principal. Fixed-income securities are subject to credit risk, liquidity risk, call risk, and interest-rate risk. As interest rates rise, bond prices generally fall. Mortgage-backed securities are subject to credit risk, interest-rate risk, prepayment risk, and extension risk. International investments can be riskier than U.S. investments due to the adverse effects of currency exchange rates, differences in market structure and liquidity, as well as specific country, regional, and economic developments. These risks are generally greater for investments in emerging markets. All charts and tables are shown for illustrative purposes only.
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