August 2023 / VIDEO
The Rising Cost of Capital: Bond Implication
Time to rethink fixed income portfolio
After languishing near zero for over a decade, US interest rates have risen at the fastest pace in modern history. It’s a tightening policy that’s been mirrored by central banks around the world.
For now, financial markets appear remarkably unaffected. Labour markets remain buoyant, economies are still growing and equity markets have rebounded strongly from their October 2022 lows.
T. Rowe Price’s fixed income investment professionals believe things are set to change. During Free Talk, a biannual Fixed Income Webinar, they believed we are likely witnessing a classic lag between central bank policy action and its after-effects.
And as signs of recession begin to appear, they went on, it’s time to add duration to a fixed income portfolio.
We are firmly in the neighbourhood of policy errors
According to Arif Husain, Head of International Fixed Income and Chief Investment Officer, Fixed Income at T. Rowe Price, central banks may already have raised rates too far in their quest to quell inflation.
“We are now firmly in the neighbourhood of policy errors,” Husain shared.
Central banks are looking backwards: their models for forecasting inflation haven’t worked. I worry that they are now likely to overtighten policy,” he said.
There are other factors adding to the risk of a market accident, said Husain.
First, investors are too complacent about the possibility of rising defaults. Second, the energy supply outlook is still uncertain as a result of the Russia/Ukraine war. Third, since the global financial crisis a lot of leverage has shifted from bank balance sheets into the shadow banking system, where it’s harder to monitor and control.
Meanwhile, said Husain, the monetary stimulus that was added by central banks in late 2022 and early 2023—in response to the UK pension fund crisis and the failure of several US regional banks—is beginning to wear off.
“Our proprietary indicator shows all the stimulus in the system,” said Husain. “It combines monetary policy, fiscal policy and what banks are doing. In the early part of this year, we saw a big upturn in stimulus.
But now our stimulus indicator is starting to roll over due to the lagged effect of interest rate rises. We now have all the conditions for a rising default cycle.”
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August 2023 / INVESTMENT INSIGHTS
Arif Husain is the head of Global Fixed Income and chief investment officer of the Fixed Income Division. He is chairman of the Fixed Income Steering Committee and a member of the firm’s Management Committee. Arif is lead portfolio manager for the Global Government Bond High Quality Strategy. He is a vice president of T. Rowe Price Group, Inc., and T. Rowe Price International Ltd.
