2nd May 2015 by Chris Iggo
The bond market had a tantrum this week. Bund yields more than doubled. The German government bond index lost 1.5% in total returns. Yields moved higher in Treasuries and UK gilts. Is it the end of the bull market? Is it the start of the bear market? Market behaviour is not conclusive either way, largely because the fear of illiquidity is preventing most participants from committing much risk capital to a strong active view. What I take from the recent price action is that more and more investors are avoiding negative or very low yielding bonds and more and more think that reflation is actually taking place. Bank lending in Europe is starting to increase, oil prices have stabilised and US wages are picking up. Inflation markets have responded to that and should continue to do so. Everyone has thought bond yields would rise at some point. Reality check – it might be now.
Yields up…is it for real? – It’s May but it is cold and a big shiver went through the bond markets this week. It was like there was a collective realisation that negative bond yields just don’t make any sense and that, save for some economic catastrophe, interest rates will rise over the medium term. German 10-year bund yields more than doubled this week (not very often you can say that but equally not very often bond yields are at 15bps which was the level of 10-yr bund yields last Friday compared to today’s 37bp) and yields on all core bond markets moved higher. This was despite further prevarication from the US Federal Reserve (Fed) following the release of a weaker than expected Q1 gross domestic product (GDP) growth estimate. Experience should tell anyone operating in this market that the impact of economic data on market prices is not always as one would expect. Just as bond yields have fallen during periods of strong economic data they can just as easily rise when there is disappointment. No, the rise in yields had little to do with the data but more to do with the dynamics of supply and demand in the euro bond markets, re-positioning and a lack of liquidity. It does now seem that there is little genuine demand for bonds that have negative yields. Those institutional investors that are forced to hold lots of fixed income already do and the marginal buyer appears to have disappeared because it is hard to find a financial relationship where a negative yielding asset is providing a positive cash-flow relative to a liability. Even those players that have bought bunds on the speculation that yields could go even more negative have probably capitulated by now. So it is likely that we have seen the lows. Another compelling argument is that banks in the euro area, in both the core and peripheral markets, have enough government bonds on their balance sheets now and instead are starting to make loans that attract a much more attractive return. We always thought that the combination of the asset quality reviews, intensive capital raising in the banking sector and quantitative easing (QE) would ultimately lead to a resumption of credit growth to the private sector. It seems that we are now getting that.
It is likely to go further eventually – It’s interesting psychologically to observe and acknowledge market behaviour and “chatter”. While many people, including ourselves, have long held the view that the bond market has been manipulated by QE and that bond yields should be higher, there are those that almost accepted the “normality” of negative yields and helped perpetuate the fiction of “no growth and no interest rate increases ever”. The latter fight every move higher in yields and latch on to every piece of weaker than expected economic data – failing to distinguish between the effects of bad winter weather, the reduction in capital spending associated with reduced oil exploration and production, and the genuine underlying strength of the economy as evidenced by ongoing employment growth and wage gains. But even the former group, those that think yields will go up at some time, are often reluctant to conclude that this is it. They might be right. Yields may not rise very much when the Fed is still unsure of when to raise interest rates and the European Central Bank (ECB) and Bank of Japan (BoJ) are still massive buyers of government debt. But it may be that we have seen the lows in core bond yields and that yields will move higher over time, even if not in a straight line. Market timing is difficult but to me there is a good reason to position a bond portfolio very defensively in regards to interest rate exposure. That means lower duration by having more short-dated bonds, floating rate instruments and cash, and focussing on yield through having exposure to credit where the spread is compensating for credit risk. At the moment there aren’t many opportunities to do that but US high yield remains attractive as do parts of the subordinated debt market such as AT1 bank debt and corporate hybrids. I don’t get the impression that there are lots of “short” positions in the rates markets at the moment so this week’s moves will have been painful to a lot of market participants, especially as the moves haven been across the yield curve. Both the UK and German markets saw big moves in 30-year bond yields.
Inflation expectations are rising – The timing of a Federal Reserve rate hike is still not clear and we need to see more Q2 growth data before there is any more clarity. The Fed had little new to say in its statement after the latest Federal Open Market Committee (FOMC) meeting but the market is very much focused on the weakness of the activity data from Q1. I am a little more interested in the inflation data. One report this week was consistent with a tightening in the US labour market and that was the Employment Cost Index report for Q1. Wages and salaries increased by 0.7% in Q1 to stand 2.6% higher than a year earlier. This is not quite back to pre-crisis levels of wage growth but is certainly moving in the right direction. The week also saw more evidence of rising house prices (Case-Shiller index up 4.22% year on year) and oil prices have been grinding higher. This has been met by higher break-even inflation rates in the bond market. Indeed, this has been one of the clearest trends in recent weeks. In the US TIPS market the 10-year break-even rate has moved from a low of 1.53% in January to 1.93% today. Similar moves has been seen in the UK linker market and in European inflation linked markets. Break-evens – the difference between the yield on nominal government bonds and inflation linked bonds – were at very low levels for much of Q1, providing investors with a very nice opportunity to hedge inflation risk over the medium term. Flows that we can observe in the bond market suggest that many investors did indeed increase their exposure to linkers. With QE ongoing, the Fed still reluctant to raise rates, oil prices perhaps firming further and global growth modestly improving, the moves in inflation markets can continue.
Liquidity, liquidity everywhere but not a drop to price with – The great bond bull market might have come to an end and there might be some nasty times ahead for fixed income investors. If there are and we see a disorderly re-pricing across the whole asset class, liquidity will be a major issue. It is common knowledge that banks are unable to provide the same levels of liquidity that they once could because of the more expensive use of capital that market making entails. It is common knowledge that investment vehicles such as ETFs are more important (bigger) in the bond market than ever was the case. We know that bonds are expensive and that many investors won’t need a great deal of encouragement to start redeeming their bond holdings. So what happens when market sentiment turns negative on bonds, investors start to redeem their holding through selling directly into the market or withdrawing money from bond funds, and dealers are unable to hold bonds on their balance sheets so make prices that try to deter sellers from dealing with them or at least provide them with a fair chance of re-selling the bonds at a better price? It will be carnage. There will be massively increased price volatility, large mark-to-market losses and perhaps some systemic increase in financial instability. The price action is likely to be out of line with fundamentals. Even in the 2008-2009 period very few actual bonds defaulted but hundreds had their prices marked down significantly as investors tried to reduce their exposure to credit. According to Moody’s there were 14 investment grade defaults in 2008 and 11 in 2009 (89 and 203 for high yield markets) in the worst credit market ever. The point is that because of the lack of liquidity, if we get a significant sell off in bond markets the pricing will reflect a default expectation that will be several multiples of what is likely to actually transpire. We would not put credit fundamentals in anywhere near as poor a state as they were in 2008 given the amount of leverage in the system back then. As a result, there will be opportunities to re-invest in bonds when prices fall – even though, at the time, it will feel like completely the wrong thing to do. The question is, who will have the firepower to do that? Banks themselves don’t have spare capital so a market recovery will depend on institutional investors putting their cash back into the market or distressed bond funds that have been waiting patiently to buy high yield at proper “high “ yields. Again, who knows when the liquidity event will strike. It could be related to higher rates – there have been complaints this week about awful liquidity even in the US Treasury market – which could in turn spark wider credit spreads. It’s difficult to prepare but, just like for the argument to reduce interest rate exposure, holding higher cash balances is probably a wise thing to do today. After all, the opportunity cost of holding cash rather than bonds is very low (although not quite as low as a week or so ago).
Left-Right-Scottish – A week from now the UK will have a new government, or maybe it won’t. The opinion polls still don’t indicate any of the major parties being able to command an overall majority in the House of Commons. A lot can change in the run-up to polling day but it does seem that this election will be more or less a straight slugging match between the Conservatives and the Labour Party. What is different is the Scottish National Party (SNP) having a significant pop at both of them. The SNP could win most if not all seats in Scotland but neither Labour or the Tories want to enter a coalition with a party that exists, fundamentally, to achieve independence for Scotland from the rest of the United Kingdom. A Tory/Liberal Democrats coalition (again) combined with SNP dominance over Scotland is not going to make for a very harmonious Union and it will only serve to breed further resentment about the lack of representation on English matters from English voters. For the markets this can’t be good and it certainly will be very confusing to overseas investors, especially those that have put money into Scotland. I bet the biggest victim of a messy outcome to the election is sterling and if the US data strengthens in Q2 and the Fed is on track for a rate increase in September then a sterling-dollar rate in the low 1.40s again can’t be ruled out.
Top four, deja vu – I guess congratulations are in order to Chelsea. They should clinch the Premier League title this weekend. Say what you will about Jose Mourinho, he has a track record second to none for a manager that is still relatively young. Chelsea have some great players but the team as a whole is not always that attractive to watch, largely because of the coach’s “don’t lose” mentality. I’m sure they will be hard to beat again in 2015-2016. Arsenal should also be commended for having a strong second half of the season and getting to the FA Cup final for the second year running, playing their distinctive passing game. City look like a club with real problems but it will be a familiar top four representing England in the Champions League next year with United looking safe in 4th place at the moment. It’s not been a vintage season but great if you live on the South Coast – Bournemouth versus Southampton in the Premier League next year! I wonder if the Cherries can attract some top players to help secure their place in the top flight – a house on Sandbanks should just about do it for someone.