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When things become ugly

Although individual days, hours or indeed minutes may be quite exciting, there’s an uneasy calm about bond markets at the moment. “There’s very, very little activity just now; we’re all in ‘Wait and see’ mode,” says Pictet’s Christel Rendu de Lint. Waiting to see the Federal Reserve move interest rates, that is. “We have been a reasonably narrow trading range – between 4-4.5% for 10-year Bunds and 3.9-4.5% for US Treasuries – for about six months now. Even when the Fed changed its wording and used the ‘patient’ word, the market quickly got itself back into a (higher) trading range again after the initial sell-off.”
And the recent US payroll data didn’t fool many into changing their positions too radically either. “Yes, at 112,000 jobs the figure was weaker than the 175,000 expected, but this does nothing to diminish our confidence in the US economic recovery,” states Adrian Owens, co-head of global fixed income at Julius Baer. “In fact I’d put it more strongly than that and say that we dismiss that payroll number – all of the other evidence indicate that the increase in jobs is coming through. If we look at the household survey, for example, it shows average monthly jobs growth in the second half of 2003 of around 200,000 versus between 50 and 60,000 per month in the payroll report. This disparity between the two surveys of labour data has happened before in the early 1990s. In fact Bush Senior lost the election on the electorates’ gloomy assessment of the economy in part because the jobs’ data appeared to be so weak. And yet six to 12-months later all the numbers were revised up.”
“We are confident that job creation will happen in this recovery,” agrees Rendu de Lint. “If it (job growth) does not pick up immediately,” she goes on, “then we feel that the existing monetary and fiscal stimuli directed at the economy will continue to be supportive for the recovery at least in the first half of the year, when companies will then hopefully have started hiring again..”
“To us the (Government) bond markets are currently at reasonable levels,” comments CapitalInvest’s Andreas Schuster. “For the moment, we do not see why yields should be much higher or on the other hand much lower than where they are now. So we do not have big bets on right now, we are very slightly short duration that’s all. We are of the view that the US economic recovery is well underway and not in need of tax measures to sustain it.”
But with such an apparently strong recovery, why are investors not more bearish of interest rates? “One of the reasons why we are only mildly bearish at the moment is because inflation remains subdued (for now), the steepness of the curve makes it expensive to short the market and being short is consensus view,” warns Owens. “At some point this year we will look to get very short the market but, more than ever, timing is key. We need more evidence that the Fed is ready to hike rates.”
Even the outcome of the latest G7 meeting, in Florida, would have little impact on the capital markets, in marked contrast to the previous meeting. Rendu de Lint explains,: “After the meeting in Dubai last September, the closing statement included the phrase ‘more flexibility’ which the G7 ministers and Central bankers thought conveyed their desire to see the US dollar decline versus the Asian currencies in particular. However the market interpreted it as a general willingness of the authorities to let the dollar decline versus the euro. Which it did quite dramatically.”
And back in mid-2003 there was an overwhelming conviction, in the capital markets, that the dollar had to weaken, says Rendu de Lint, while today it is much harder to convince anyone that at these levels the dollar is massively over-valued.
Although some argue that the dollar is pretty much bound to ‘overshoot’ into over-sold/cheap territory, the dollar is starting to win back some fans. “We feel that most, if not all, the negatives about the US dollar are pretty much priced in to the forex markets right now,” says Schuster. “And the positive growth story for the US economy should prove to be a prop for the currency.”
Whilst there may not be too many reasons to be significantly skewing portfolio durations either shorter or longer, or taking on forex bets, managers remain on guard. “There are risks to the benign scenario,” says Pictet’s Rendu de Lint. “As well as the ever-present possibility of geo-political shocks, there’s the risk that we do see violent moves in the currencies, or that we have a commodities crisis which derails the recovery. And let’s face it, the Fed doesn’t exactly have the best reputation for engineering ‘soft landings’, do they?”
The team at Julius Baer are quite sure that things could get ugly in 2004, arguing that when the Fed does come to hike rates, there could be a painfully large sell-off. “Banks are huge players of the carry-game, borrowing short and playing the carry trade, investing in such products mortgages and other swap related instruments. When short rates are eventually raised, the bond market sell-off could be massively exaggerated by the unwinding of these trades. And the possibility of a vicious sell-off won’t be confined to the Treasury markets, but may happen in other arenas where it’s been a good place for carry trades most notably emerging markets, and high yield.”
In the meantime while sitting around and waiting, there’s still plenty for these active managers to do. For Pictet, it has been the declining volatility which has provided investment opportunity with strategies based on shorting options, that is, selling volatility, rather than the market itself.”
As for Owens, he thinks he’s a bit luckier than most as he runs both conventional fixed income funds as well as hedge funds. “The safest bonds to own right now? That’s a difficult one. However, if you’re asking me what we could do, it would be to put on pair trades,” says Owens, “that is shorting one market and going long a different one. In these range bound, nervous markets it’s a good way to make money.”

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