Central banks have been the driving force behind fixed income markets since the global financial crisis. In an attempt to ignite growth and spur inflation, they have expanded their balance sheets by enacting unprecedented monetary policy and flooding financial markets with liquidity. As an example, the Bank of Japan now owns over 30% of its government bond market, and the European Central Bank has increased its holdings of European government bonds by nearly 10% in the past year.
The weight of this cash has caused bond yields to continue their move lower over the past eight years, forcing investors into higher yielding sectors in order to meet return targets and generally manipulating the nature of fixed income investing. Many investors have based their outlook on the assumption that this trend of central bank support will continue for some time to come, which has been warranted given rhetoric from key central bank officials like Mario Draghi and expected reaction to political events like Brexit.
However, it is imperative to consider what could derail this central bank support given how much impact it has had on markets. While not our base case, it is possible that we see a shift away from monetary policy toward fiscal policy as governments grapple with the reality of diminishing returns on further quantitative easing measures. Most recently we have heard hints of this shift out of Japan, where Prime Minister Shinzo Abe’s election win has caused speculation that a fiscal spending package up to JPY 20 trillion could be announced as a means of combatting the persistently weak economy and creating inflation in a low yielding world. Other countries that have exhibited a tendency toward fiscal policy response include Germany, where government expenditure has contributed an increasing amount to GDP, and China, where the budget deficit has been rising in an attempt to maintain their growth trajectory. Should this trend play out, it would pose the threat of a sell-off and steepening of government bond curves globally.
While central banks have been the dominating factor over the longer term, technical factors – particularly on the demand side of the equation – are driving markets in the near term. With an increasing number of government bonds dipping into negative yielding territory, investors are looking for returns outside their domestic fixed income markets. As a result, we have seen a surge in demand for high quality, relatively high yielding assets such as US investment grade corporates from Japanese and European investors. The search for yield has also been evident in the emerging markets (EM), where EM debt received the largest weekly inflow in two years and EM equities received the largest weekly flow in more than three years. Similarly, US high yield, Euro high yield and US equities have all experienced strong demand over the past few weeks. As long as these flows persist, we believe that fixed income markets will remain well supported. Though it’s always important to keep an eye on the unexpected!