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The Bank of England has intervened in the bond market again and warned about risks facing the UK’s financial system. Greg Bonnell speaks with Scott Colbourne, Managing Director, Global Active Fixed Income at TD Asset Management, about the financial uncertainty facing the global bond market.
Transcript
Greg Bonnell: There are more signs of strain in the financial system. The Bank of England once again needing to intervene in the bond market and warning of a “material risk” to stability. But do these cracks suggest that the central banks are going to pivot away from rate hikes? Is that back on the table? Joining me now for more, Scott Colbourne, Managing Director Active Fixed Income at TD Asset Management. Always great to have you on the program, Scott. The Bank of England having to step in again. There wasn’t a one and done occasion. How should we be reading this as investors?
Scott Colbourne: Yeah, I think it’s an important topic to follow. I mean the whole debate as to whether the Fed remains bearish and committed to the inflation fighting mantra and the fissures, I guess, if we’re starting to see in the market. And this is an example of the pressure in the gilt market where it’s been disorderly and the Bank of England has stepped in.
So I think this is sort of what the market is coalescing around, this concept of financial stability and the worry that it might bring. And it really feeds back into what’s the most important thing for governments. And that’s the ability to finance their debt. And if they can’t have a functioning debt market, then it is really, everything else becomes superfluous to that. And a broken bond market is really quite concerning.
So we’ve got the Bank of England using these or extending this tool that they have had to sort of mollify the volatility in the gilt market. And that’s one example. Obviously, we have this also in Japan where they’re using yield curve control but they also have dysfunctional bond markets that aren’t trading as well.
So it’s sort something to keep in mind. But I think at the end of the day for me, is this the evidence or is this the catalyst for a pivot? I come down on the no side. I don’t think that this is sufficient enough to break the Fed at this time. And there’s a variety of reasons we can sort of dig into that.
Greg Bonnell: Let’s do that, right, because the Fed and all the other central banks, for the most part, in the Western world, have been singing from the same playbook. Listen, we know you might lose your job. That’s pain, we got to do it. We’ve got to tame inflation. Hey, we know we might fall into a recession. That’s the pain we just have to accept. But people do wonder, well, once it gets to the bond market, then can they really ignore that?
Scott Colbourne: Yeah, for the time being I think it’s too early to talk pivot and it’s too early to talk peak hawkishness from the Fed. The mantra since Jackson Hole has been very consistent from Fed speakers. There’s no room for nuance here. We’re committed to inflation and we’re going to continue that song. As you said earlier, we get CPI this Thursday. It’s still unacceptably high. It has peaked. I’m in that camp. But it’s still very high. It’s coming down. Core inflation is still high. Yes, it’s coming down but there’s evidence that it’s a bit sticky.
So for the time being, with that in mind, and you’ve got OK growth. We had reasonable non-farm payroll last week. I think that problems outside of the United States, as they say, our dollar, it’s your problem, right? It’s not enough for a systematic issue in the markets. It’s not broken anything domestically. It hasn’t changed their view on what growth will be or inflation. So we can suggest that we’re getting close to an inflection point but I don’t think you’re going to see any change. We’ve got about 125 basis points baked in between now and the end of the year. I’m pretty sure we’re going to get there and then more some next year.
Greg Bonnell: Do we end up in the– and this is the other debate too, right? Once they finally get to where they want to be at that terminal rate and then you pause, because you’ve sort of reached the end of the mission, then you have people saying, well, then they’re going to cut fairly soon after that as well. And I haven’t had many people sit in that chair recently say, don’t hold your breath for a cut after that. It’s probably going to be a pause and a hold. Is that how we’re seeing things?
Scott Colbourne: I think that’s the reasonable expectation at the moment. I mean, when you look back through most of this year, the pivot from aggressive rate hikes to a quick cut seemed a little out of sorts. I think given the backdrop, we are in an inflationary regime. We haven’t been in this regime for a long time and this has changed central bank reaction function. To expect them to quickly move from terminal rate to cutting without something meaningfully breaking, more in the US market than anything else, then, no, the Fed is not going to quickly cut the rates.
But you are starting to see nuances around the world in other central banks. They’re not as hawkish. But I think the Fed has its lane way and it can stay hawkish for the time being.
Greg Bonnell: That sort of leads us to a question in terms of other central banks going their own way. It was Australia, right, that delivered a hike but perhaps not as big of a hike as expected. Do you see other regions of the world, just based on purely their circumstances, saying, well, we know the Fed is doing this thing but we can do our own thing here?
Scott Colbourne: Yeah I think you’re going to get a little bit nuanced. There’s difference of nuances between central banks. So RBA is supposed to go 50, it went 25. So that was a little bit of a surprise. When you look at what’s priced in in Canada versus the United States, there’s a gap that has opened up between Canada and the United States. Even though I would say the Bank of Canada and Tiff Macklin are on the hawkish side of the spectrum of central bankers, the markets are saying there’s room to see a differentiation next year where the Fed might get to 4.75% or 5%, we’re looking at perhaps the Bank of Canada at 4.25%, maybe 4.5%. And that gap opening up is a little bit of say, look, there’s some things here domestically that are going to drive things differently, perhaps it’s the housing market, and the impact of inflation on consumer spending.
Perhaps we’re looking– there was speculation about Germany looking at underwriting a bond across the EU to support the energy market, or the energy shock that Europe has undergone. And you’re seeing evidence that perhaps at the margin you’re going to get slightly different nuanced takes here than what the Fed is pushing ahead with. So, yes, there is evidence, and on the most dovish extreme is the Bank of Japan.
Greg Bonnell: Let’s talk a bit more about that. Because that is curious, right? I mean, basically, there doesn’t seem to be a market right now for Japanese bonds. What is happening and how serious is that?
Scott Colbourne: It’s very serious. I mean, when we see these episodic losses in the US dollar, right, the yen rallies or the risk market rallies, I mean, we’re in a bear market and the US dollar is king. And occasionally we get these sentiment or position driven rallies. And we had a brief episode where the Bank of Japan intervened in the market to stem the depreciation in the currency because, basically, they’re the only buyer of JGBs. And they’ve got yield curve control and they’re capping interest rates. And they continue to do that while the rest of the world, in particular the Fed, the interest rate gap opens up and there continues to be pressure on their currency.
And so it is at odds with what’s the broad global trend. But it is leading to a depreciation in their currency and a lack of proper functioning in the JGB market. We haven’t participated in the JGB market in long decades here, and we won’t. It’s dysfunctional and driven by primarily one buyer.
But some would say that this is an example, if the government bond markets broke and you needed support, you could see yield curve control grow elsewhere. And to what extent– the intervention that we’ve seen by the Bank of England is not yield curve control and it’s not QE. But do we need this ultimately down the road to cap long-term rates and make for bond markets to be more stable for government financing? That’s an interesting question to explore and some people are raising that.
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