AXA IM: Fixed Income in COVID-19: Adapting to protracted low interest rates

Aidan Yao, Senior Emerging Asia Economist and Jim Veneau, Head of Asian Fixed Income

The COVID-19 pandemic has widened several fault lines that existed before the crisis struck. Income inequality, big power geopolitical tensions, and the separation of financial markets from the real economy through central bank interventions have all been exacerbated by a public health crisis on a scale not seen in generations.

Central bank put: A toolbox easier to open than shut

Amid the immense shock, central banks have taken unprecedented steps to prevent the global economy from collapsing into a depression. Their actions have resulted in what we believe is a paradigm shift in the management of monetary policy. This has manifested in a rapid expansion of central bank balance sheets to contain a wider variety of assets, thereby monetising fiscal deficits – which allows governments to target liquidity injections. We have also seen a more audacious intervention in market forces that enables central banks to not just set the price of money, but also influence the value of credit, equities and other risky assets.

Central banks have defended these actions as necessary responses to the economic shock and have vowed to withdraw them once the crisis is over. But just like the quantitative easing enacted after the 2008 global financial crisis, shutting off the liquidity tap could prove more challenging than opening it.

There are several reasons for this. First, the global economy remains on thin ice despite the recent improvement in sequential growth. While the exit from economic lockdown will spur a mechanical rebound in the second half of this year, most economies will not revert to their pre-crisis levels until well into 2021.

This projection is also predicated on the coronavirus being a one-off shock, which may prove too optimistic given the resurgence of cases in the US – the world’s largest economy – and challenges controlling the outbreak in important emerging market economies like Brazil, Mexico, Russia, South Africa and India. Prolonged delays in growth resumption could enlarge the output gap, perpetuate economic damage and hold back central bank policy normalisation across the world’s economies.

Second, the inflation outlook is murky. Even if inflation does make a comeback, the US Federal Reserve has already signalled its willingness to tolerate price increases above the mid-point of its target band after undershooting the target for so long. As a result, without sustained inflation, central banks may find difficult to justify an exit from current policy settings.

Third, a dramatic increase in debt is paradoxically likely to limit any interest rate rise. One of the few known consequences of the current crisis is an explosion of debt as a result of the high levels of stimulus. Fiscal debt ratios of developed countries may surge towards 200% or even 300% of GDP, while private sector leverage will be elevated by the emergency borrowing that kept businesses alive through tough times. With a mountain of debt, even a small increase in interest rates could derail the global economy’s fragile recovery. Knowing from history the danger of premature policy withdrawal, few central banks will be willing to risk an economic double dip in the pursuit of policy normalisation.

At the end of the day, no central bank will want to be held accountable for crashing the market. Given how much liquidity has helped fuel a protracted bull market, essentially since the start of quantitative easing, it is hard to imagine how asset prices will not deflate when that liquidity is withdrawn. Moreover, with central banks now the largest holders of many risky assets themselves, any actions that could cause a market reset must be weighed carefully against potential damage to their own balance sheets.

We think ultra-accommodative monetary policy is now entrenched. Not only are policy rates likely to be ‘nailed to the floor’ for the foreseeable future, more innovative tools – such as buying risker assets, yield-curve controls, or even negative interest rates – could also be introduced if the current stimulus is deemed insufficient to keep the economy afloat. Therefore, zero, or near-zero, interest rates could become a de facto baseline in the global monetary environment to which all investors need to adjust.

Yield is harder to reach

In the fixed income space, with interest rates at historic lows, generating yield becomes an elevated challenge. The need for yield to fund longer-term liabilities of institutions and the savings of retirees could potentially compel investors to either add duration – accruing more interest rate risk by migrating further out along the yield curve – or to increase credit exposure by moving lower down the credit curve with increased exposure to lower-rated issuers of bonds.

The former approach, however, will be unlikely to give much return for the added risk as the entire risk-free curve (usually US Treasuries) is flattened and suppressed by central banks’ quantitative easing, leaving little term premium to satisfy investors’ needs. Credit exposure, on the other hand, could potentially be more effective in generating a stable and attractive carry, especially with the Fed providing an effective market backstop by pledging to buy corporate bonds. We think the search for yield augurs well for Asian credits, and better relative fundamentals within the region will help offset the need for central bank backstopping of corporate debt.

Mind your duration

Another challenge facing fixed income investors is managing interest rate risk, especially with monetary policy in uncharted territory. While we don’t see any imminent risk of rising inflation forcing central banks to tighten, we also don’t think negative policy rates will be implemented pervasively even in a worsening economic environment, thus effectively retaining the zero-lower bound for monetary policy. The most likely scenario going forward is interest rates oscillating along a very low and flattish path.

On balance, we see interest rate risks tilted to the upside (i.e., rising rates), for the simple reason that global policy rates are already at rock bottom and cannot go much lower. Investors who concur with this view will need to be mindful with their duration exposure. All factors being equal, lower rates/yields mean higher duration, which means higher portfolio/benchmark risk.  If – or rather, when – rates begin to rise, higher portfolio duration will likely mean larger negative price moves.  Portfolios with low spread/carry cushions will typically incur larger mark-to-market losses and higher volatility. 

We are now standing in a world confronted by a global pandemic, severe economic contraction, and unprecedented policy intervention. The key takeaway from this is that central bank influence is the paramount, perhaps even dominant, but still not the exclusive investment consideration for fixed income investors. Portfolios should continue to potentially benefit from active decisions on credit and duration that are well researched and timely to the evolving macro environment.