Differences of opinion can get ugly
Global bonds and currencies
Newton Fixed Income
March 2011
Paul Brain
No.312
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A difference of opinion is developing in the bond markets. Following a significant decline in US bond yields in the last quarter of 2010, there are some investors who suggest that bond yields will rise substantially, while others remain more complacent. Two key factors to consider in evaluating bond markets at the moment are the extent of the Federal Reserve's ("the Fed's") involvement in those markets, and the sustainability of the current economic recovery, not least in light of higher oil prices.
We were of the opinion in October 2010 that the Fed's second round of quantitative easing ("QE2") was already priced into markets, and that its actual commencement would provide investors with an opportunity to sell bonds. Recent media comments suggest that some investors have fully exploited this central bank demand and have reduced their positions aggressively. Getting ahead of these investors has been pleasing, but where do we go from here? Will fears over rising short-term interest rates culminate in the start of a proper bear market in bonds?
In the debate about bond yields, the bears seem to have the upper hand. The question of who will buy US Treasury issuance once QE2 ceases in June is the primary concern (although even here, the experiences of the UK in 2010 might give the bears pause for thought), but it should also be remembered that economic recovery and rises in headline inflation rates are factors which are usually negative for bonds. On the other hand, there are some investors who point to a number of risks in this scenario, as well as flaws in the pricing logic, which we will explore. First, the idea that the pace of expected nominal GDP will rise to 5% p.a. seems overly optimistic in this recovery phase and deleveraging (debt repayment) adjustment. Secondly, when using core inflation figures, the level of real yields (bond yields less inflation) is relatively high (see Chart 1).
Chart 1 US 10-year yields less US core inflation
There is also the possibility that the economic recovery may stall in the second half of the year as government stimulus wanes and the QE2 programme ends. The more compelling suggestion that developed market economies are undermined by rising oil prices is a further genuine worry, as wages are unlikely to keep pace with the rise in headline inflation, which will reduce consumer spending. Meanwhile, the US housing market recovery and eurozone rebalancing process require interest rates to remain low, otherwise both are in danger of a sharp retreat.
So where do we stand in this debate? Back in October we suggested US 10 year government yields could rise towards 4% and, given all the other uncertainties, much higher rates would seriously threaten the whole recovery. For now, we intend to stick to that target and maintain a short (but not aggressively so) position in US bonds. In a debate on US government bonds yields, we cannot forget that the prices of US Treasuries are used by much of the market as a 'base' price. If US yields do rise substantially, which could only happen when the Fed is in a position to raise rates, then the rest of the bond market (corporate bonds, mortgage bonds etc.) will be seriously affected. To see what could happen in that scenario, we refer to the experiences of 1994 as a guide. At that time, much market pricing incorporated anticipation of a low and stable central bank interest rate. This illusion was first shattered by the German Bundesbank, and then by the Fed.
This leads us to one of the most important differences of opinion regarding the situation today. The Fed and the European Central Bank seem set to follow different interest-rate policies over the coming six months. History has shown that such differences of opinion can become problematic for the markets and for particular currencies. US dollar weakness has lingered for some time, and the eurozone continues to fight its peripheral battles; if the eurozone issues are resolved, then the euro could continue to recover against the US dollar. The disasters in Japan suggest that Japanese monetary and fiscal policy will stay very loose for the foreseeable future. Some investors believe the yen could be a major funding currency for foreign-exchange traders (through sale of the yen and subsequent purchase of other currencies with more attractive interest rates), but others believe that repatriation of foreign assets by Japan will counteract this trend. These differences of opinion are likely to result in volatility, which could get ugly. We believe that repatriation is a near-term support, but lower credit quality and the loss of production are longer-term negatives.
A defensive position ("Plan A") in bond markets and reduction of underweight yen and euro positions is an appropriate stance to take while the outcome of crises in North Africa, the Middle East and Japan remain uncertain. "Plan B", appropriate for when economic growth recovers to the point at which markets price in a shift in developed-market monetary policy, and which is bearish for government bonds, may have to be postponed.
In the UK this document is issued by Newton Investment Management Limited, the Bank of New York Mellon Centre, 160 Queen Victoria Street, London, EC4V 4LA. Registered in England No.1371973. Newton Investment Management is authorised and regulated by the Financial Services Authority. In the UK, the opinions expressed in this article are those of Newton Investment Management and should not be construed as investment advice. This is a financial promotion and is not intended as investment advice.
