Fixed-income: Time to add duration to portfolios
Positive real long-term interest rates, expectations of future cuts in benchmark rates, and fixed-income's diversification effect make this a good time to think about adding duration to porfolios
The central banks are winning the battle against inflation that they have had to wage over the past 12-18 months, depending on geography. The increase in prices is beginning to tail off as we enter a period of higher interest rates. In the article we published in March: A new yield environment for short-term fixed-income we discussed the significant change that was occurring in short-term low-risk investment options, where it was possible to find levels of returns that largely mitigated the negative impact of additional interest rate hikes.
Another milestone was reached recently for the first time in a decade in Europe and in the last two years in the United States: not only are nominal interest rates much higher, but medium-term real interest rates (5 years) are positive.
Additional rate hikes to reach the terminal rate in the main developed countries
Source: Calculations by Santander.
Level reached by central bank interest rate hikes relative to expected terminal rates
Source: Bloomberg economists' consensus. Survey on 8 March 2023.
2.5% vs. 1%
Change in the price of a 5-year bond vs. change in the price of a 2-year bond in the face of a 50bp decrease in interest rates
Source: Calculations by Santander.
Easing inflation and higher nominal rates lead to positive real interest rates
Source: Bloomberg US Agg Index 5-year expectations of inflation in the United States (USD Inflation Swap Forward 5Y5Y). Data as of 02/06/2023.
Source: Bloomberg Euro Agg Index and 5-year expectations of inflation in the Euro area (EUR Inflation Swap Forward 5Y5Y). Data as of 02/06/2023.
The "last mile" of monetary policy
After two years in which monetary policy has become steadily more restrictive, starting (and ending in some cases) much earlier in emerging countries than in developed countries, we have reached, or are about to reach, the “terminal rate”, the point where interest rates stop rising.
What can we expect in the coming months?
Interest rates are already pretty tight but, given that the effect of monetary policy is subject to a lag, we will have to wait to see the full impact on the economy. Therefore, the pause should last a few months, during which central banks will foreseeably continue to monitor inflation and also the intensity of the economic slowdown. The historical average pause in monetary policy by the US Federal Reserve is about 5 to 6 months. Faced with marginal rate hikes in the short term, the market is focusing on when the first rate cut will come.
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