October 8, 2020
To maintain liquidity in a bond market that struggled during the initial impact of Covid-19, the US Federal Reserve (Fed) has been purchasing long-term bonds with newly printed money. What does this mean for Treasury bond yields, future inflation expectations and the US dollar? Scott Zaleski, manager of the BNY Mellon Global Fixed Income Strategy, believes it may be time to consider fixed income exposure abroad.
While US inflation is not exactly a near-term worry, Zaleski believes it may still be appropriate to start positioning portfolios now.
“If you want diversification, away from the risk of US inflation, we’re not waving a flag saying head for the hills today—but when inflationary pressures do arise in the US, a global portfolio should protect better than just being exposed to a local market,” he says.
Because the Fed is printing new money to accommodate fresh policy stimulus, Zaleski believes it could exacerbate inflationary pressures in the US. The prospect of printing new money, which can be inflationary in of itself, he adds, creates greater risk of inflation further eroding the value of the greenback when consumer activity does pick up.1 The heightened risk is not solely due to the rate at which it is printed, but also because the US’s money supply started from a relatively larger base this year, Zaleski says.
Separately, in August the US Department of the Treasury said it was expecting to borrow US$2trn over the remainder of the year to pay for pandemic-driven measures,2 largely by issuing more Treasury bonds.
“The projected increase in Treasuries is extending the Bloomberg Barclays US Aggregate Index3. As a result, you have more Treasuries, more duration and less yield in the index. Therefore, by focusing on just the US you’re more concentrated and possibly getting less real return that can be found abroad,” adds Zaleski.
Particularly on long-term Treasury bonds, the Fed has added pressure to yields over the past few months by focusing its purchases on the long end of the yield curve.4 According to Zaleski, higher yields may be found in sovereign bonds in other countries without drastically increasing volatility within their portfolios.
“There is opportunity for higher yield in countries that are well positioned and have lower leverage. At the same time, hedge that exposure back to the US dollar and pick up yield relative to US Treasuries, and it may not have the same inflationary pressure that we think US holdings could have,” he says. “To the extent it is possible to buy outside the country and earn a return higher than the inflation rate in the US, it gives capital the potential to move higher without that inflationary pressure eating away principal.”
While the rest of the world may not be immune to an eventual rise in inflation, a global bond portfolio could provide the ability to diversify inflation risks across several countries while potentially achieving higher real yield than US Treasury bonds.
A large basket to pick from
One country Zaleski currently views as attractive from a yield standpoint—and where he believes there is less of a worry of inflation—is Australia. Unlike the US, which has been purchasing bonds at the longer end of the yield curve, the Australian central bank, the Royal Bank of Australia, primarily makes its purchases on the short end, which helps control short-term yields, but allows longer-term yields on their sovereign bonds to be higher.
“They use the shorter end of their yield curve to provide liquidity to their economy as much of their consumer lending is based off of short rates, while the long end has moved higher, attracting outside capital. We’ve found a good amount of value in the Australian market,” Zaleski says. “From a developed market standpoint, that’s one of largest relative allocations we have because it also has a lower correlation with US rates, which provides somewhat of an offset to market volatility.”
The reduced correlation between the Australian and US fixed income markets stems from the fact that the former is rebounding slower from a GDP standpoint and has a lower debt-to-GDP ratio,5 according to Zaleski. He adds that the coronavirus pandemic has impacted developed market countries at different rates so there’s the added benefit of desynchronization between some central bank responses.
For similar reasons, he believes bonds in some of the European periphery countries are attractive. These include Greece, Italy, Cyprus and Portugal – whose sovereign bonds provide higher real yields and whose debt is being purchased by the European Central Bank as supportive monetary policy, which allows for further spread compression relative to the European core, adds Zaleski.
If inflation begins to become a worry outside of the US, there are also currently over 25 countries that issue inflation-linked bonds (ILBs), Zaleski says. In some of these countries, a rise in inflation is considered so unlikely that it is possible to access ILBs without compromising on yield.
“In a country like Japan, where inflation expectation are close to zero, you’re essentially able to buy ILBs with similar yield to that of their nominal counterparts. In other words, those ILBs grant inflation protection for very little costs,” Zaleski say. “We’ve also used them when a particular country’s currency is weakening, which creates inflationary pressures.”
For now, Zaleski expects the US dollar to continue weakening, partially because of the increased money supply. Since June, after the Fed ramped up on easy monetary policy, the US Dollar Index, which measures the performance of the dollar against a basket of other currencies, has been on a downward spiral, recently reaching its 27-month low.6 When inflation eventually does kick in, it could further devalue the dollar. However, rather than quelling his inflation worries by solely accessing Treasury Inflation Protected Securities (TIPs)7, a market Zaleski says can be less liquid and relatively volatile, he has also been shorting the US dollar and adding global currency exposure.
Zaleski and his team can have an allocation of up to plus or minus 10% of a 100% hedged currency position in their portfolio. Any larger and it introduces additional volatility, he says. Aside from running a 7% short on the US dollar, which further symbolizes his belief that it will continue weakening, he has also been adding exposure to global currencies.
“The Japanese yen is a currency that’s an attractive hedge against increasing global volatility. We’ve also been using the Canadian Dollar as a proxy for the US dollar because we think there’s going to be more volatility in the US, and Canada has done a better job with the pandemic” he says. “The US has a larger stimulus package and increasing deficits, which we think could put further pressure on the US dollar relative to other currencies.”
Additionally, he says currencies in Scandinavian countries like Norway and Sweden may be more attractive relative to the EUR, as well as in European emerging markets like Poland because of its higher yielding currency and he believes it stands to benefit from a rebound in the manufacturing cycle due to an improving Chinese economy.
In essence, Zaleski is taking precautionary measures to prepare for the future. One only needs to look at the size of the US government’s economic stimulus, as well as indicators like the falling value of the US dollar, as evidence that inflation will turn up eventually. While job gains have yet to match pre-pandemic levels in the labor market—and some even contemplate the possibility of future economic lockdowns— inflation can come from the shadows and threaten bond portfolios at the least expected times. It is then that it can help to have some flexibility. During periods of increasing inflation over the past 15 years, global bonds have offered protection vs. US-only portfolios, according to Zaleski.
“With a global fixed income portfolio, you have the opportunity to diversify risks outside of the US where you can potentially pick up more yield. You also have the ability to select where you want take credit risk, where you want exposure to securitized products, or if it’s optimal to take currency positions in other countries,” Zaleski says.
“You just have so many more levers at your disposal to protect principal and provide returns compared to if your fixed income allocation is solely in the US,” he concludes.
1 The Bond Buyer: What does the future hold for inflation? September 1, 2020.
2 MarketWatch. Treasury sees $2 trillion in borrowing over the rest of the year
3 The Bloomberg Barclays US Aggregate Bond Index is a broad base, market capitalization-weighted bond market index representing intermediate term investment grade bonds traded in the US.
4 Seeking Alpha: Should The Fed Buy Treasuries Or Agency MBS During QE? September 3, 2020.
5 CNBC: The pandemic will make European bonds more attractive than their US peers, economist predicts. September 21, 2020.
6 International Banker: Is the US Dollar’s role as the world’s reserve currency under threat? September 30, 2020.
7 Inflation protected bonds in the US
Bonds are subject to interest rate, credit, liquidity, call and market risks, to varying degrees. Generally, all other factors being equal, bond prices are inversely related to interest-rate changes and rate increases can cause price declines. The use of derivatives involves risks different from, or possibly greater than, the risks associated with investing directly in the underlying assets. Derivatives can be highly volatile, illiquid, and difficult to value and there is the risk that changes in the value of a derivative held by the portfolio will not correlate with the underlying instruments or the portfolio’s other investments. High yield bonds involve increased credit and liquidity risk than higher-rated bonds and are considered speculative in terms of the issuer’s ability to pay interest and repay principal on a timely basis. Investing in foreign denominated and/or domiciled securities involves special risks, including changes in currency exchange rates, political, economic, and social instability, limited company information, differing auditing and legal standards, and less market liquidity. These risks generally are greater with emerging market countries.
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Asset allocation and diversification cannot assure a profit or protect against loss.
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