In recent weeks, we have seen significant volatility in bond markets after the Fed outlined a possible plan for the ‘tapering’ of its QE programme. The Fed’s buying of US treasuries and mortgage securities has been a key supportive factor for bond markets, so it’s understandable that investors are seeking to re-calibrate their positions in response to this. However, amid all the media hype and exaggerated talk of ‘crisis’, it is important to keep a sense of perspective about what the Fed is actually saying and what the impact of its actions might be for various parts of the bond markets.
Focus on the Fed
The singular focus of bond markets has been firmly on the Fed and its QE tapering plans. The Fed said that it could begin moderating or tapering its QE buying activity later this year, gradually slowing down its purchases, possibly to the point of a complete cessation of buying by mid-2014. The key thing to note here is that tapering is not the same as outright tightening in the conventional sense – indeed, the Fed was very careful to keep its position on the Federal Funds Rate entirely separate. The other key point is that the Fed’s outline of its tapering plan is not set in stone; it is data-dependent. If unemployment fails to fall sufficiently, then tapering could be delayed, reduced or reversed. Whenever tapering begins however, it will be worth bearing in mind that US monetary policy as a whole will still be very accommodative by historical standards.
Looking at what the market reaction has been to-date, since the Fed’s announcement, the yield on 10-year US Treasuries moved up by about 100 bps to about 260bps before settling back into the 240-250 bps range. When we were considering the fair value of these bonds and the impact of the removal QE some time ago (when yields were 1.6%), we thought that they were 100bps beyond fair value, so with yields at current levels, it seems the market has moved to discount the impact of QE very quickly. In fact, it is possible that yields could have spiked a bit higher than they did but a key limiting factor has been the patchy US recovery, with only modest jobs gains and, crucially, a complete absence of inflationary pressures.
Looking ahead, while volatility is likely to continue, we expect that the generally stable inflation picture will continue to act as a brake on yields. In fact, coupled with the increasingly uncertain outlook for Chinese growth and the negative impact of this and dollar strength on global commodity prices, inflation could move lower in the future. On balance then, the current pricing of US 10-year Treasuries looks reasonable, with fair value being less than 3.0% based on the current data and outlook.
Turning to other global bond markets, yields in Europe have of course been dragged higher by the recent increase in US bond yields. However, it is possible that the extent of the increase may have been more than warranted given that the overall economic situation in Europe, particularly in the periphery is still poor. Data from Italy, Spain and Greece is still indicating a contraction in GDP. Meanwhile, positive data coming out of Germany, particularly around retail sales and sentiment, is being offset by bank credit contraction to some extent. Taking account also of the extremely benign inflationary backdrop, a good case for the ECB to continue easing can easily be made.
The real issue in Europe though has been the two-speed nature of the recovery, with the largest economy, Germany, doing well, while the periphery has remained weak. The ECB continues to face a policy dilemma and history suggests that its most likely response will be to do nothing, effectively ‘kicking the can down the road’, with the result being that interest rates remain stable in the immediate future.
In terms of emerging market debt (EMD), we have seen a significant jump in yields for emerging market debt in recent weeks. Indeed, for the week ending June 26, market data showed that some US$5.7bn was pulled out of emerging market debt funds – the biggest single weekly movement in the history of emerging market debt. The key thing to note however is that recent EMD weakness is certainly not due to any specific fundamental factors but mainly owing to technical factors.
Looking ahead however, we think that some kind of bounce back from oversold conditions may be quite likely as investors recalibrate and start re-focusing on the generally favourable fundamentals. Our order of preference here would be first, shorter duration markets in local currency terms, then hard currency bonds and finally emerging market foreign exchange, this being the most challenged area owing to weaker growth and the stronger dollar.
High yield markets
In the high yield market, spreads have moved out significantly since the Fed outlined its possible plan for QE tapering. Indeed, we believe that the size of the move means that the valuations of individual assets in this space represent good value.
A key factor that has helped to push yields up of late has been poor liquidity – in fact, fundamentals have remained generally favourable, supported by very low corporate default rates. Indeed, investors may begin to question the price moves on such low volumes - we are seeing a marking down of assets during volatility and a marking up of those assets when risk sentiment improves and liquidity returns. Nonetheless, the tendency of liquidity to dry up in the high yield markets during periods of notably heightened volatility is something of a concern.
Investment grade credit markets
Investment grade credit is where many bond investors tend to have the bulk of their assets. Encouragingly, investors are still showing an appetite for these assets, which are fairly priced, and we are not seeing much selling pressure. However, investors should be wary of companies engaging in M&A activity and succumbing to the temptation to leverage up their balance sheets. Fundamental credit research is critical to avoiding credits with a deteriorating outlook.
We are seeing very little inflationary pressure at present with weaker commodity prices and the disinflationary effect of a more stable dollar. However, looking further out, the danger is that if and when the velocity of money picks up then inflationary pressures could also spike up significantly. For investors wishing to protect against this risk, an allocation to index-linked bonds can act as a very effective insurance policy.
Interestingly, inflation-linked bonds are presently very cheap relative to history, particularly if you take the view that the ‘wall of money’ central banks have injected into the economy in the form of QE does pose an inflationary risk on a medium-term view. While it is not a trade likely to reward investors quickly, it is nevertheless a very relevant and thoughtful strategy, which can be implemented quite cheaply right now.
Andrew Wells is Global Chief Investment Officer, Fixed Income at Fidelity Worldwide Investment.
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