Why you should be watching the bond yield curve
In this week’s video insight Roger discusses why investors must keep a close eye on the bond yield curve and watch out for a sustained steepening, where long term bond rates rise. If the difference between short-term and long-term rates continues to widen, it keeps more pressure on central banks to buy long-dated bonds in an attempt to keep the yield curve flat.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
Ricky Leong
:
There is an assumption that higher inflation will directly translate to higher interest rates.
But nobody knows if this assumption will hold true. I think it’s worth examining more closely for the following reasons
1) The RBA has said that it won’t increase rates until it sees sustained inflation, strong wage growth and low unemployment. Yet the pattern of past recessions is that it takes years to restore wages growth and full employment. The economic scars of covid run deep – entire industries have been destroyed and hundreds of thousands of jobs are not be coming back.
2) The RBA is also extremely constrained in its ability to increase interest rates. Increasing rates from 0.1% to 2% would effectively double mortgage rates for homeowners – crushing the property market and triggering widespread mortgage stress. The RBA can only raise rates very slowly and it’s unclear how we will ever get back to “normal” settings.
3) It’s quite possible that central banks are willing to tolerate higher inflation. This will help highly indebted households and governments inflate away their debts while avoiding the agony of EU style austerity.
4) It’s quite possible that central banks will face both elevated inflation and high unemployment. This is a tough dilemma as Increasing rates will worsen unemployment while cutting them will fuel inflation. Its a quite possible that central banks choose to prioritise jobs – wearing higher inflation while using QE to pin down the yield curve.
Roger Montgomery
:
True Ricky. If however inflation does get out of hand, it lowers the standard of living for everyone and so will be tackled.
Ricky Leong
:
I agree that if inflation gets out of hand it will be eventually be tackled. However – it’s important to consider:
1) What do central banks consider “out of hand”?
2) Will they tackle inflation using conventional policies or unconventional policies
With relation to point 1, The Fed and RBA have already redefined their inflation target to apply “over the economic cycle”. Given that inflation has undershot considerably in recent years, I suspect central banks may be comfortable with inflation of 3-4% inflation in the short to medium term.
With relation to point 2, government and households are both so indebted that central banks will find it extremely difficult to raise rates. It’s quite possible they will resort to unconventional policies to manage inflation. E.G. macro-prudential regulations for the housing market, increases to the super manade or even limited wage/price controls.
Roger Montgomery
:
Hey Ricky, I concur but keep in mind what the RBA does at the short end, might not change the market’s reaction at the long end of the yield curve.
brad northfield
:
If bond yields continue to rise with velocity, interesting to see how long the ARC followers stay loyal for. With the amount of FUM for ARC exploding in the past 12 months, interested to get your thoughts on how much the market could be affected by a mass withdrawal of funds from ARC if this was to occur.
Roger Montgomery
:
Hi Brad, I was at a lunch today at which the ARC story came up. if the velocity of trading in ARC exceeds the ability of ARC to liquidate its holdings, a gap will open up between the ARC price and the value of the underlying portfolio. This has occurred in ETFs previously. If an ETF with ARCs profile is hit by such a spread widening, perhaps blind faith in ETFs is given sight.