Waiting for the break
With the holiday season almost here, there is almost tangible sense of relief in the bond market. Whilst one might expect investors and players in equities to be tired out by the vacillations and stomach turning downward lurches in stock markets, fixed income investors seem to have been equally drained by those markets’ vacillations. And this is in spite of the fact that the lion’s share of bond markets, Government bonds, have been doing reasonably well. So why this fatigue?
According to Lombard Odier, it’s been a few months of nervous tension. “These are not easy markets,” says head of fixed income, Paul Cavalier in London. “We would all like to see more stability. There has been a huge increase in volatility over the last three years and many people have taken active steps to decrease their risk – by selling stocks and credit and buying Government bonds for example. We do not believe that the (equity) markets are currently focussing on macro-economics and whether it (the US economy) is about to suffer a double dip; as far as we can see the economic recovery is on track. Even if some recent numbers have been a bit weaker, they are still coming from a high base. The equity market weakness is about investor risk aversion.”
Markets are not looking to fundamentals, says Eric Brard of SocGen Asset Management in Paris. “We have the apparent paradox where bond markets have been appreciating in line with strong economic data. What the markets seem to be expressing is doubt about the fundamental background and basic fear of developments in risky assets. Just look at emerging market bonds which have been suffering badly lately.
“Add to this some ‘Enronitis’ with its massive implications for the way corporate profits should be measured in the future and it all amounts to a lot of risk. So it is perhaps not too surprising that investors should be going back to Government bonds both here in Europe and in the US.” Brard goes on to add that, although he agrees with the picture of an improving economic outlook suggesting rate hikes on both sides of the Atlantic, it is still not the time to be bailing out of Government bonds. “It is difficult to say that these markets are expensive right now. In this global environment of increased risk-aversion we cannot rule out more declines in yields. We are duration underweight in the US, but we prefer Europe and are neutral there.”
Having had quite big duration positions, the team at Allianz/PIMCO feel that now is the time to be neutral. Matthieu Louanges goes on: “Through 2000 and 2001 we were aggressive with our macro bets in terms of duration, yield curve and volatility plays and we balanced this with much less risk and exposure to credit. Many of our expectations – for spread widening, lower bond yields and steeper yield curves – were realised and in the last six months we have been closing our underweight credit position.
“Fundamentally there is no strong case for a bull market in bonds, excluding the risks of exogenous shocks including that of a crash in equities which is not part of our base scenario. Government bond yields are at historical lows, especially at the front ends and we just do not feel that now is the time to be betting on capital gains,” argues Louanges. “That said, with such steep yield curves, particularly in the US, you lose so much carry if you are short. So unless you have a strongly negative view on the US, which we do not, then it is best to be neutral.”
Cavalier says: “It is a difficult call, and more so in the US than in Europe. In Europe the market, and we agree with it here, expects the ECB to tighten before the Federal Reserve as the Euro-zone economy continues to do well and inflation remains above the 2% target. For the US, perhaps it is a little expensive right now but short rates are about right. And we would be sellers into strength. But it is unlikely that the European market will trade that differently to the US. It should remain a good way to play their trading relationship and add some value: US Treasuries outperform in up markets and Bunds tend to make it up in down markets.”
“We are forecasting an ECB rate hike in the summer,” say Allianz/PIMCO. “The market is going for 50 basis points (of tightening) by year-end, and we would argue that this is the minimum to expect. And risk is asymmetrically skewed towards higher rates, so we do not think there is much protection at the front end. In fact what we are doing is slightly barbelling the curve, with higher cash and a slight overweight in the 30-year. Our fear is that the ECB will not be particularly aggressive when it does come to tighten, fearing that it might jeopardise the recovery, and that it could be perceived as insufficient to tackle the threat of inflation. If this is the case then the worst place to be on the curve is the 10-year.”
Louanges goes on to suggest that the very long ends of European government markets are supported by the increase in natural demand for long dated paper. In the Netherlands and Denmark and to a lesser extent in Germany and France too, there is a fundamental asset allocation switch within pension funds, out of equities and into bonds, he says. And on the other side of the equation, governments have been looking to fund much less at the long end and tap shorter maturities. Whereas the bond markets seem to be the source of angst and soul-searching, it appears that the same is not true of the currency markets where things seem to have gone much more according to the (fundamental) plan. “We have had much better performance here than in bonds. We did very well in the recent run up in the Australian and Canadian dollars for example,” says SG’s Brard. “We have been long the euro – like almost everybody else – and have enjoyed the run-up. In fact we are still long; the dollar is still over-valued and those investment flows into the US, which did so much to drive up the value of the currency during the late 1990’s, are drying up.”
“Yes we too have had the long euro/short US trade on,” sighs Louanges. “But at least it is now looking like it could be turning into a good trade, at last! The huge current account deficit in the US could not be financed indefinitely and now that the corporate and portfolio flows have fallen off so much the euro looks set to go further. Or forecast is for the euro to be above parity by year-end.”