Fixed-income roundtable: Part 1

 Brian Miron, portfolio manager for Fidelity Investments in the fixed-income division of Fidelity Management & Research Co. Based in Merrimack, N.H., Miron manages a large number of mandates including Fidelity Canadian Bond, Fidelity Corporate Bond and Fidelity Tactical Fixed Income.

 Michael McHugh, vice-president and head of fixed-income at 1832 Asset Management L.P. His responsibilities include Dynamic Canadian Bond and Dynamic Advantage Bond, as well as the fixed-income components of the balanced offerings.

Morningstar columnist Sonita Horvitch moderated the discussion. Her three-part series begins today and continues on Wednesday and Friday of our fixed-income theme week.

Q: It has been some 18 months since the three of you participated in the previous Morningstar fixed-income roundtable. Much has happened since.

Locke: In the early part of 2013, we had a sense that the U.S. Federal Reserve Board's policy of quantitative easing would continue for a while. Then there was the mention in May of the possibility of the introduction of a tapering program. That set off the rapid rise of the whole yield curve through the rest of 2013, with the U.S. 10-year rate peaking to close to 3% in September and then reaching that again in December 2013. The Canadian yield curve followed the U.S. yield curve up. 2014 has seen a fall in interest rates, which started at the beginning of the year.

Steve Locke and Brian Miron

Q: Why have they fallen?

Miron: That is a great question. It has confounded a lot of economists, strategists and investors. Going into the year, most economists were forecasting a rise in interest rates over the course of 2014. There were a variety of shocks at the beginning of the year that set the trajectory for interest rates. There was an economic-growth scare in many parts of the world. China reported weaker economic data and there was weakness in other emerging economies. U.S. GDP growth surprised significantly to the downside. Canada's growth and Europe's growth also disappointed. There were geopolitical concerns too. Russia and the Ukraine caused concern both from the political perspective and also from the perspective of the impact of this on the European economy. Then there were the ongoing concerns about the Middle East.

Most recently, there has been a de-synchronization of global monetary policy. The U.S. Federal Reserve Board has continued to reduce the amount of its fixed-income securities purchases with its tapering program. At the same, the Bank of Japan stepped in with more aggressive quantitative easing. Most recently, the European Central Bank has cut its leading interest rate and is considering asset purchases. So Japan and Europe are in easing mode, while the Fed is moderating its accommodation.

McHugh: Prior to the taper tantrum last May, the fixed-income environment was characterized by a high degree of complacency. A lot of money was being allocated to income securities at progressively more expensive valuations. The result was that the magnitude of the move in the bond market could be much greater than that justified by the economic fundamentals. This is what happened with the taper tantrum in May 2013, which resulted in the dramatic sell-off in the bond market. U.S. bond yields have steadily declined in 2014, despite the move by the Fed to persistently reduce its asset purchases.

Q: At what stage is the Fed in its bond purchases?

Locke: The Fed is going to end its bond-purchasing program this year, which, in some people's minds, paves the way for it to potentially raise rates as we go into 2015.

Michael McHugh

Miron: Keep in mind that the Fed funds rate is at emergency levels.

Locke: It has been for about six years.

Q: The Fed funds rate is currently 0% to 0.25%.

Miron: U.S. economic growth is on track for the full year, with growth in the region of 2.5% to 3%. Does that warrant emergency-type interest rates? The Fed is likely thinking that it does not. It probably wants rates to be somewhat higher, but not significantly higher. It does not want to shock the economy, but, at the same time, it wants to stay ahead of the market.

McHugh: One of the challenges that the Fed and other central bankers face is that the longer these extraordinary monetary policies are in place, the more difficult it is for central bankers to move away from them. The Fed's zero-rate policy has impacted the pricing or mispricing of certain assets. The risk of changing that reference rate for pricing these assets is an exaggerated reaction in financial markets, as we saw in the summer of 2013.

The Fed has to start normalizing interest rates at some point. This means increasing its rate until it reaches a positive real yield (after inflation). The projections as to the timing of an initial Fed funds-rate increase in 2015 range widely.

Locke: The earliest projection that I have seen is March 2015.

McHugh: We think that there is a high probability that the Fed will initiate its first rate hike around the first quarter of 2015. Some projections call for this to take place in mid-to-late 2015. The end rate for the Federal Reserve Board in its rate-raising exercise is probably 2% to 3%. The challenge will be to get there. In that process, there are bound to be some disruptions, whether it is in the economy or in financial markets, which makes the Fed's trajectory of normalizing its policy rate, the Fed funds rate, difficult to ascertain.

Locke: I agree with Michael that the Fed's terminal rate is something around the 3% mark.

Q: What are U.S. bond yields and other key bond yields, at present?

Steve Locke

Locke: At recent count, the rate on the 10-year U.S. Treasury was 2.4% and the Government of Canada 10-year rate was 2.08%. These rates are in sharp contrast to the 92 basis points for Germany's 10-year bonds and the 53 basis points for Japan. This U.S. Treasury 10-year rate spread to the 10-year German Bund rate is the highest it has been in 15 years. This allows the Fed to pursue a differentiated monetary policy from its peer central banks.

Miron: This de-synchronization of monetary policy is having global asset- allocation implications. You take a look at 10-year Government of Canada bonds at 2.08% and that is a considerable yield advantage compared to Germany and Japan. Funds will flow to the higher-rate countries. This has important implications for the currencies of all the countries.

It must be emphasized that a move by the Fed to raise rates is a dynamic process. If the U.S. central bank starts to raise rates and the market reacts or overreacts, and it has an impact on the economy, that will change what the Fed will do.

Q: The consensus is that the U.S. Federal Reserve Board will raise its policy rate in 2015. Michael thinks it will be sooner rather than later. Can the Bank of Canada be far behind?

Locke: It will be an issue of timing. Canada's policy tends to mirror to some degree U.S. Fed policy in terms of where to set the rate and the direction of change over the economic cycle. Bank of Canada Governor Stephen Poloz can pursue an independent policy for a period of time to achieve a certain aim.

Miron: The Bank of Canada rate is currently 1%. This is still fairly low by historic standards. It is still accommodative, but it is not at emergency levels.

Locke: Poloz is focused on boosting exports and Canada's global performance. By lagging the Fed's potential move on the Fed funds' rate, this gives Canada a way of seeing a small devaluation in our currency against the U.S. dollar to help our exports. This means that we keep our rates stable, as the Fed moves towards tightening. We are starting with a higher policy rate to begin with. As the Fed closes that gap, there will be some increased pressure on the Bank of Canada to follow.

Miron: The Bank of Canada has specific marching orders to keep inflation in the 1% to 3% band. It is still currently under 2%, so inflation is not an imminent concern. Hence there is no real need for the Bank of Canada to change monetary policy. This supports the conclusion that it is going to lag moves by the Fed.

Photos: paullawrencephotography.com

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