Black Hole Sun

Chris Iggo -

It’s a bit nervy in the bond market at the moment. We can all see reasons to sell but are worried that when the time comes we won’t be able to

Greece might cause a credit market wobble, the Fed might cause another rates market wobble and the traders might all be on holiday. The more it seems no agreement can be reached with Greece, the more investors will sit on their hands. That makes for a summer of trouble, so it may be best to de-risk, raise cash and head for the beach. On the optimistic side, valuations might improve and there is likely to be a lot of cash waiting to invest once things settle down. The ECB can provide some stability, European government bond redemptions will add to the cash in portfolios and the economic fundamentals are still positive. Some risk-off might be coming, but a buying frenzy could follow thereafter. H2 2015 looks as though it could be very interesting.

Bad moon rising

Bond investors are nervous at the moment. Actually, we are always nervous because being a bond investor is to have all your risk the one way – the risk of not getting repaid. But at the moment things are particularly tense. There is not a lot of good news. First there is Greece. At the time of writing it is looking like the situation could get a lot worse before there is any resolution to the impasse between the current Greek government and the institutional creditors. The risk of non-payment to the IMF, the imposition of capital controls and a failure to reach any agreement on a new bailout programme is higher than ever before. While Greece may not be that important economically (2% of Euro Area GDP) and the systemic financial risks are less than they were in 2011, a “Grexit” still has major implications. To me the most important of these are the credibility damage done to a currency union that was supposed to be irrevocable and the potential geo-political risks in the eastern Mediterranean of economic and – potentially – social and political unrest in Greece. Volatility has increased in recent week and risk assets have started to underperform, but I fear there is worse to come if the “Grexit” scenario becomes more likely. That leads me to the second concern for bond investors, the impact of QE on valuations and positioning. Bouts of QE have pushed investors into lower rated parts of the fixed income markets through the search for yield. This has led to a liquidity shortage in very low yielding core government bond sectors (as recently evidenced during the Bundshock) and crowded positions in peripheral debt, subordinated credit and high yield. Whether it is a realistic concern or not, we are told on a daily basis that there is a massive problem if investors exit those crowded positions quickly given the lack of liquidity in bond markets and the lack of obvious buyers. This becomes a little self-fulfilling as bond portfolio managers de-risk their portfolios and raise cash levels to anticipate potential outflows. Spreads on other European peripheral government bonds have widened and there has been some credit spread tensions (CDS indices are much higher since early April), but I wouldn’t say we have had a huge move. The risk is that credit spreads do move a lot wider. The third reason for nervousness is the Fed. The feeling amongst Fed watchers is that this week’s FOMC and the publication of the Fed’s latest forecasts suggest that there is still a dovish tone to the policy outlook. However, the message is also that the Fed does want to get on with the job of tightening – it’s the precise timing of the lift-off and the pace thereafter that remain uncertain. To me both the timing and pace will be determined by what happens to inflation in the US. The year-on-year CPI rate remained at zero in May but since February – following the bottoming of the oil price – the CPI index has risen at an annual rate of 3% with the core CPI rising at an annual rate of 2.4%. We are not in deflation in the US. Instead we are in a nominal GDP growth world of 4% to 5%. Rates need to be higher. Bond investors are nervous that Fed tightening will lead to higher yields and spreads.

Spirit in the Sky (or Grossmarkthalle)

With all this nervousness around, investors need to be reassured that there is a least one supportive factor in the bond market. The ECB has continued to pledge that QE will continue until September 2016 as planned, and could even extend beyond that date. Mario Draghi may have urged investors to “man-up” and accept more volatility, but he still provides the biggest bid in the market. We are in the midst of our quarterly review of the outlook for fixed income and in more than one of our discussions with external economists and strategists the potential for the ECB to provide even more liquidity came up. If there is a “Grexit” then, politically, Europe will put the blame fair and square on the Greek government and in order to persuade other doubters in Europe that they are better off staying in the Euro Area, there is likely to be a major initiative to calm markets down. If that means more focus from the ECB on buying peripherals then that is what we will probably get. I’m not even sure we get that far as that as a deal with Greece is still achievable but either way there will be a buying opportunity in Spanish and Italian debt. We can question the morals of the scenario in which Greece is cut loose from the European economy to descend into a period of even more rapid economic decline while Europe moves to protect other peripherals, but that might be the reality of the situation in the extreme. The message being, play by the rules and you will benefit from QE and, by extension, continued low interest rates that will help you progress towards debt sustainability.

Opportunities (let’s make lots of money)

Nervousness means reducing risk and building up cash buffers. My sense is that many investors are waiting to re-invest but they would like to see higher yields before doing so. Given what I have already said, we could see those higher yields soon as a result of getting closer to the Fed rate hike or because of a risk-off valuation adjustment related to Greece. As I have said many times, we still like the fundamentals for credit and high yield in the context of a global economy that is doing alright. We also know that the potential for increased demand for fixed income is there and becomes evident when there are new issues coming to the market. There have not been many of them in Europe recently, given the increase in volatility, but I suspect the last third of the year could see bond markets become very hot again. Whatever happens with Greece will become clear in the next few weeks. During July, there will be a massive squeeze in the European government bond markets as a result of huge bond redemptions which will put even more cash into investors’ hands. There could certainly be an opportunity for buying high yield in Europe with a 5% yield on the index in the weeks ahead, and for buying Spanish and Italian debt with the 10-year spreads above 200bp. With the net supply (QE adjusted) of European government bonds becoming hugely negative, total returns might then be very strong in the run up to year end.

Go Your Own Way (?)

The Bank of England has not been in focus recently given the events in Greece and with the rise in Bund yields last month. However, it is hard to see the Bank not raising rates soon after the Federal Reserve does. It’s a similar story to that in the United States. The labour market has continued to tighten and there are starting to be signs of this leading to wage growth. In May the UK unemployment rate remained at 5.5% but average weekly pay growth picked up to a rate of 2.7%, the strongest pace of growth since 2009. The current unemployment rate is the second lowest cyclical level of the last thirty years, only going lower than that in the credit boom of 2004-2008. Retail sales growth has also been relatively strong – rising at a 4.5% y/y pace in recent months, again consistent with periods of rising interest rates in the past. If the Fed is able to make the case that the US economy is strong enough to withstand a modest pace of monetary tightening over the next year, it won’t take investors long to read across and come to a similar conclusion for the UK. Gilt yields could come down again in the near term if there is “Grexit” turmoil – though I suspect that the US Treasury market will be the biggest beneficiary of Euro related volatility – but later this year the gilt curve could steepen further if the BoE follows quickly after the Fed. .

Safe European Home

The much awaited divergence of monetary policies between Europe and Japan on the one hand and the US and UK on the other hand could become more real in the second half of the year. The Fed and BoE can’t delay indefinitely a response to the US and UK economies approaching full capacity or the need to have some monetary policy tools in hand should there be another downturn, while the ECB will certainly face a need to retain its high level of accommodation to sustain the early recovery in the Euro Area. Some people worry that the Fed won’t be able to tighten because it will bring even more dollar strength or cause too much of an increase in long-term rates which will hurt the housing market recovery. This is the same as saying you can never tighten monetary conditions because something will always react negatively. The reality is that financial conditions in the US are very loose and the economy should be tough enough to withstand what is likely to be very gradual tightening. The key will be the inflation numbers. Under the central case, the dollar probably does strengthen further and a rest of parity against the euro is likely to be seen. European and Japanese equities could continue to outperform the US market because of that. A stronger dollar and higher US interest rates remain negatives for emerging markets, especially considering the slower growth path of China. For bonds, Europe is probably safer one we get past Greece, although the Bundshock tells us we don’t need to have a big change in the macro picture to have bouts of volatility, particularly at the kind of valuation extremes we reached in Q1.

19th Nervous Breakdown

Other reasons why people in the bond market might be nervous. They think something bad always happens in the summer months when asset managers and bank traders are on holiday. They worry that a growing number of people in the industry have never actually experienced a rate hike. Brexit. Anti-Euro parties in other countries than Greece respond to the Greek situation by becoming even more vocal and challenging to the mainstream. I could go on. The point is that there is always something to care about. To manage money in this uncertainty takes a focus on understanding cash-flows, credit risks and sensitivity of portfolios to volatility in interest rates, currencies and equity markets. Nearly all bonds pay their interest and principal back on time and in full. There is always marked to market risk and the one-way evolution of the bond market in recent years has probably come to an end. Rates will move higher eventually. However, investors need to focus on what level of yield they want to achieve, what level of capital preservation they desire and what risks they want to avoid. The bond market might provide some interesting opportunities on all fronts in the months ahead. For the short term though, Keep Calm and Carry On.

Chris Iggo – CIO, Global Fixed Income – AXA Investment Managers (AXA IM)