In recent weeks, the big focus in financial markets has been the surge in US government bond yields, and whether this surge has further to go. As a baseline view, we believe this represents an attractive opportunity to earn yields that have been difficult to achieve for over 15 years.
However, there is a scenario where bond yields rise further, even if only temporarily. While today’s high yield creates a sizeable buffer before price losses outweigh the 12-month yield on offer, the main worry is that ‘something breaks’ because of much higher borrowing costs. Historically, a sharp rise in yield has coincided with events such as corporate defaults, sovereign defaults or stress among some financial market players.
How can investors hedge against such a scenario? US government bonds may, somewhat counterintuitively, work as a safe haven. Besides their attractive yield, bond yields tend to fall (ie. bond prices rise) when markets enter a ‘risk-off’ environment.
Geopolitical risks have unfortunately been a relative constant for financial markets in recent years. In each case, the market’s worry has been whether a disruption to energy supplies leads to a jump in prices, creating a channel for geopolitical risk to translate into financial market risk.
While not our base case, an energy price surge disrupting markets would raise several related questions. Would the Fed respond to the likely associated jump in inflation expectations? Would the higher energy price ‘tax’ hurt consumer spending? Is a repeat of what happened in the 1970s – when oil prices and inflation soared, forcing central banks to aggressively hike rates – likely?
While we do not subscribe to the 1970s analogy (for one, energy had a much bigger share of economic activity than it is today), a significant jump in energy prices can nevertheless be a significant challenge to financial market assets.
One potential hedge here is energy sector equities. While we do not see them as a preferred sector in our base case, their relatively high correlation with oil prices arguably makes them an attractive hedge against an energy price surge.
A third possible risk is the possible fallout from significant appreciation in the Japanese yen. Over a 12-month horizon, we do believe a stronger Yen is likely. The Japanese yen is currently held down by the Bank of Japan’s policy of keeping Japanese bond yields extremely low relative to other major bond markets. We have often argued that this policy is likely to come to an end, leading to higher Japanese yields and a stronger yen. The yen, in turn, has a long history of large moves over short periods of time.
This can be a source of worry because the yen’s low yields have made it popular as a source of funding. This raises questions over the degree to which other global asset classes may be impacted should the cost of this funding rise sharply and suddenly. Of course, the Bank of Japan has been at pains to ensure bond yields rise only slowly following its recent policy shift, but the risk of a more sudden move in the currency is not off the table.
The yen itself, or yen-denominated assets, can offer a relatively direct hedge against such a scenario. We prefer Japanese equities. While these are likely to face some temporary volatility if the yen surges suddenly, we find them attractive for more longer-term fundamental reasons. This scenario also argues for minimising yen-denominated borrowing, despite (seemingly) attractive low borrowing costs.
(Manpreet Gill is Chief Investment Officer for Africa, Middle East and Europe at Standard Chartered Bank’s Wealth Management unit)