A yield race to the bottom

The disconnect between the real economy and the performance of various asset classes continues to deepen. Commentary about the relationship between the two has been widely covered by market participants, as traditionally markets had a high positive correlation to good news. In more recent times, however, this relationship has become warped, confounding seasoned investors.

Since the onset of the massive quantitative easing (QE) programs enacted by central banks following the financial crisis in 2008-9, the behaviour of markets has changed; what in financial terms we call a “regime” change.

Put simply, traditionally positive economic news would imply better financial conditions and by inference prospects for companies, creating a greater demand for their assets, and pushing their assets’ value higher.

In the QE age, central banks lowered interest rates and flushed markets with liquidity, creating the perfect conditions for companies to flourish. It created an environment of lower costs of financing, and thus, being able to afford a more leveraged capital structure and invest in their businesses. This has led to higher earnings potential which equity investors deem attractive. Furthermore, lower interest rates led to a lower cost of risk, pushing asset valuations higher from a fundamental perspective.

In credit, yields tumble, as companies are able to refinance at lower rates given the huge level of liquidity in the market. The lower interest rates make the sustainability of their capital structure more attractive, and further increases demand for fixed income assets, driving yields lower.

The only way the cycle will break is if inflation expectations rise and central banks consider raising rates once again. We already witnessed the pull back in financial markets, dubbed the “taper tantrum” when the Fed had announced it was scaling back its easing program in 2013.

Consequently, even before the pandemic, central banks became the “sugar daddies” of financial markets. We ended up in the perverse situation where positive economic news is interpreted as the potential for central banks to reverse their dovish stance, and resulting in assets trading lower.

Given the vast impact that the pandemic has had on world economies, institutions doubled down on the level of support given, and introduced fiscal measures to sustain their economies even further. This unprecedented level of support saw a quick snapback of financial assets, and today, fuelled by an end in sight to the pandemic, has pushed financial assets to record levels in many asset classes.

In the credit space, given that most companies managed to refinance their liquidity needs in 2020, the reduced level of new issues coming to market has further increased the technical bid in the market, putting even more pressure on yields. The term “high yield” has become relative, as in real terms yields have arguably become not so high anymore.

Given the fragility of the real economy, I believe we are still some way off from the risk of any policy changes in the short term; however, I would expect some volatility in the marketplace once central banks and governments alike start to signal that they will be tapering their accommodative measures.

The full, indefinite, freedom of movement and reopening of businesses, particularly in the services sector, backed by economic data, could be deemed as an inflection point in terms of market timing in my opinion. Until then, the expectation is for asset prices to rise gradually and yields to grind tighter.

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