Government bonds set to become attractive as interest rates rise
THE lack of volatility in interest rate markets has been a theme over the last few years, as central banks have pursued a zero- interest-rate policy. However, it very much feels like this is about to change — with interest rates set to increase over the coming years.
It’s now 10 years since the dark days of the financial crisis and the global economy is finally back on its feet. The crisis resulted in a sharp contraction in economic output, a surge in unemployment and real fears of deflation taking hold across the major economies. The reaction of global central banks was to try to make conditions as easy as possible for borrowers, with zero interest-rate-policies and quantitative easing (a monetary policy where central banks buy securities from the market in order to lower interest rates and increase the money supply).
Years later, synchronous global growth and falling unemployment have convinced central banks to ease off on these emergency monetary policy measures and begin the process of interest rate normalisation. This month marks a large turning point, as global central banks flip from quantitative easing to quantitative tightening (where a Central Bank tightens monetary policy by selling the bonds it has accumulated on its balance sheet, thereby reducing money supply and increasing interest rates). This has been led by the US Federal Reserve, which has been encouraged by three years of full employment and signs that wage gains are finally re-accelerating.
The global crisis impacted economies to differing degrees, and central banks responded differently, and so are now at different stages of developing policies suitable for an economy which is no longer in crisis. What will matter most to investors closer to home is Europe and European interest rates. After a period of strong economic growth and a notable decline in the unemployment rate, the European Central Bank (ECB) reduced the size of its quantitative easing programme this year and intends to finish it in December. The interest rate market is already pricing in a rate increase in 2019 — the first from the ECB in over a decade, apart from a misstep in 2011 that had to be reversed quickly.
Interest rates are going higher in Europe and globally, and the breadth and speed of these rises will drive the return on investments. If equity markets believe the increase in interest rates will be severe enough to choke off economic growth and impair future earnings, equity prices could decline. However this is unlikely for now, as central banks are merely taking advantage of strong economic performance to remove emergency-level monetary policy.
Some well-known financial market commentators are proclaiming that for the first time in 30 years, we are entering a bond bear market. With quantitative easing already finished in the US and UK, and close to the end in the euro area, it is not outlandish to suggest that interest rates in Europe will soon move higher.
There are of course a number of things which could derail the pick-up in interest rates. However, if rates rise, this should be good news for investors and savers, as government bonds (an asset class which has had low or even negative returns in the last few years) will become more attractive. Higher yields on government bonds mean that investors will have access to an ultra-safe asset which can deliver a return — which will be a relief to pension and insurance companies trying to secure returns for their members.