Fixed income: One small world

An engineer checks readings at a ship’s automation panel.

There is developing optimism for an inventory-led recovery in global growth later this year.

Financial markets are always adapting to complex changes. Markets are driven as much, if not more, by perception than reality. Investment theories that may have worked in the past may no longer be valid as the market continues to evolve. The credibility of global diversification has been one of the long-held investment theories recently damaged by the continuing financial market crisis.

Currency and bond markets were early adapters to technology and the globalization of financial markets, allowing them to look beyond local borders. What those markets have long recognized was how closely intertwined and how small their worlds had become. More importantly, those markets learned to adapt quickly to look at things from a global perspective — how mortgage defaults in California and Florida could lead to the collapse of banks as far away as Britain and Germany.

By virtue of massive global monetary and fiscal stimulus, financial markets have seemingly calmed, and the world’s stock markets launched a spirited rally during the second quarter of 2009. There is developing optimism for an inventory-led recovery in global growth later this year. A look at global interest rates, however, shows that there are challenges still ahead.

What interest rates are telling us

First, the chart of the yield curves in the major developed economies shows extremely low short-term rates, as close to zero as central banks will allow without creating problems in money markets.

Central banks in the U.S., the U.K. and Japan have taken an additional step through quantitative easing to inject further liquidity into their financial systems. Near-zero interest-rate policies on a global scale are unprecedented, reflecting the severity and depth of the global financial crisis and recession.

Second, historically low longer-term rates indicate recovery may take some time, leading to well-contained inflation expectations. Third, with the exception of Japan, the yield curves of the major developed economies have strongly converged, reflective of how synchronized bond markets have become. The implication of this is that investors have little to gain through international diversification in the bond market.

On an annual basis, the bulk of the gains or losses from foreign bonds will come from currency risk. Even experts find it extremely difficult to predict currency movements over short to intermediate terms, as there are numerous variables (and combinations thereof) that may have an impact. In the past, most foreign exchange transactions were for hedging purposes for companies doing business outside their domicile. However, the highly liquid nature of currency markets has also attracted a growing contingent of speculators, contributing to higher volatility.

The sharp swings in currency movements make international diversification of investments hazardous, unless one is on the correct side of the currency movement. As an example, the Canadian dollar is perceived by speculators as a “commodity” currency, and is highly correlated to commodity price movements. As commodity prices have been volatile in recent years, so too has the Canadian dollar.

Investment implications

Diversification into foreign bonds is hazardous given the convergence in international yield curves, as the bulk of returns will come from currency speculation. However, foreign diversification is appropriate if there is a natural need for that currency (i.e. Canadian snowbirds living in the U.S.). Currency speculation is very difficult and is a function of trading, not investing.