Recorded 18 Sep, 2017: Antares Fixed Income manager Tano Pelosi explains what could happen to fixed income if interest rates rise, as the US fed signals the unwinding of its quantitative easing program.
Jason Hazell: Hi, today I’m joined by Tano Pelosi and we’re going to be talking about the unwind of the quantitative easing program. Welcome Tano.
Tano Pelosi: Hi Jason.
Jason Hazell: First of all I think, go back to basics. Can you just give us a refresher on quantitative easing or QE, as it’s known?
Tano Pelosi: QE is essentially, its unconventional monetary policy. It’s where central banks are buying bonds typically, although not necessarily, they could be buying equities and other types of assets. And with the express purpose of trying to get real interest rates, below the zero bound. As we know, monetary policy is really got to its end point with interest rates, nominal interest rates, hitting zero. So it required quantitative easing to take it much further, to address the big problems that came out of the GFC.
Jason Hazell: I think the US Federal Reserve has signalled that in October of this year 2017, they’ll start the unwind of quantitative easing in the US. What do you think the impact of this will be on markets?
Tano Pelosi: It hasn’t been officially announced, although it’s wildly anticipated that they’ll make an announcement as early as next week, for a start in October this year. And, I think there’re really three areas where I think the impacts will sort of manifest themselves. Firstly, I think volatility will most likely pick up and in doing so, we may see a lift in risk premiums, across the board. Secondly, I think we’ll see clearly a tightening in financial conditions and as a co-role lead to that, we’ll see bond yields rising.
Jason Hazell: On the first one with volatility increasing, vols has been very low over the last few years. So they’re related obviously?
Tano Pelosi: Yes, so if you think about what’s happened over the last five or six years, you’ve had two things really driving asset valuations. You’ve had a collapse in discount rates and that’s by virtue of bond yields falling. And the second component of the performance in asset values has really been the compression of risk premiums. And that’s also showing through in terms of compressed vol. Vol is reflecting the fact that the macro economy is on a steady gradual uptrend, no surprises. And at the same time, you’ve got monetary policy and just general policy from the authorities, that’s been well telegraphed and very well communicated. So the forward guidance is being handled much better these days, than it has in the past. Jason Hazell: And your second play is that the financial conditions will just generally tighten. Is that right?
Tano Pelosi: That’s correct. So it just stands to reason that if the Government is issuing bonds and the central banks of the world, are not buying to the same extent they were in the past, those bonds will end up in the hands of consumers, investors, retail investors, if you will. And what you’ll see is inherently a rise in debt servicing costs, which will impact you and I on mortgages. And for companies, we’ll see higher debt servicing in terms of their business lending. That’s where the rubber meets the road in terms of Main Street. But I’d also say from just an asset valuation point of view, you’d also see the rise in the discount rate. And every analyst that analyses equities and risk assets, and discounts cash flows will have to flow that through, in terms of their valuations.
Jason Hazell: And this’ll also mean that what you’re saying is bond yields will probably rise?
Tano Pelosi: There is a good chance but, there is a caveat in all this and that is, what is happening in terms of the macro economy at the same time. What are the central banks planning to do at the same time? Because clearly, there are other central banks that are sort of considering what they do, with respect to their balance sheets. And the other key consideration here is also inflation. Inflation and particularly inflationary expectations, has a very strong correlation with where term premium bond yields go. And as we know, inflation of late has been fairly benign.
Jason Hazell: Markets are forward looking right and if it’s widely anticipated the QE will start to unwind, have we already started to see bond yields rise?
Tano Pelosi: There’s been a slow but very gradual move lately. I would say still the markets are not discounting enough, in terms of what could happen. In fact, whilst we’re not arguing that there’s going to be a devastation being wreaked upon markets by central banks, we would argue there’s just not enough priced in by markets, in terms of what could go wrong. And that’s reflected I guess in the volatility measures, it’s reflected in the forwards in bond yields. In the volatility measures, they’re at 25-year lows. So there’s nothing really priced in for any surprise here.
Jason Hazell: Thanks very much for your time.
Tano Pelosi: Thank you very much.
Jason Hazell: And thank you for joining us.