Rising yields everywhere marked the end of the summer season, with US Treasuries suffering most. “It was virtually inevitable we would see some sort of a sell-off,” says CDC Asset Management’s Roland Lescure“, We had been feeling that the idyllic scenario being painted for the US economy was just too idyllic, and unbelievable.” He continues: “How could we have growth of 3.5 to 4% and inflation of 2.5% and the Federal Reserve on hold forever? It was never going to be like this”.
Lescure goes on to add that part of their own scepticism is backed by the fact that only once has a ‘soft landing’ been engineered, and that in exceptional circumstances during the second quarter of 1995 after the Mexican crisis.
According to Investec’s Paul Griffiths, there is one single factor behind the recent turbulent trading. “Let’s cut to the chase, this is about the oil price. The market view is that the Fed is on hold ahead of the presidential election, so the risks of higher oil prices feeding through to the real economy must be greater. We have seen a ‘reversion’ of the US yield curve, it has gone back to positive sloping from both 5-30 years and 10’s to 30’s. The curve’s still inverted at from 2’s to 5’s.”
Griffiths points to the irony of the bearish move coming on the back of some US Consumer Price Index (CPI) numbers which were depressed by low energy costs. He points out that, in fact lower natural gas costs were responsible for the better CPI data, and adds: “Even stripping out the energy element of the CPI, those inflation figures were still good.”
Lescure agrees with the consensus view that the US economy, although poised on a razor edge, will slow down. He continues, “The US economy has been in a vicious cycle of growth, with bullish stock markets, bullish consumers and banks eager to lend. Now we are seeing signs that the banks are becoming more reluctant to lend, in fact lending is back to levels seen in the early 1990s. It is not a credit crunch, but it is a clear sign that liquidity is tightening. And if you look at real rates, they are quite high compared to historical averages.”
So, the bond market is spooking itself unnecessarily about the dangers that lie ahead? Yes, say many investors. Griffiths says that the Investec portfolios are already positioned on the bull tack. He goes on, “This bear move is hurting us, but we believe in our fundamental analysis that we are at the top of the interest rate cycle and that bond markets offer reasonable value. We are not running scared, we believe that the inflation story is still, in spite of the oil price, going to be a positive for the market.”
As to what might be positive as far as the euro is concerned, managers are still scratching their heads. “Put whatever way – it’s undervalued, it’s overshot on the downside – the euro is not trading on fundamentals. For the last few months, in spite of improving macro-trends, the currency has been trading solely on perception and credibility,” says Griffiths.
Talk of central bank intervention has so far failed to provide any relief for the currency, which has continued to hit new lows. Investors are divided as to the efficacy of intervention. Paolo Bernardelli head of fixed income at San Paolo IMI Asset Management, believes that it could work, commenting: “The euro is undervalued, but for the moment it is difficult to find the trigger that could reverse the trend. In the currency markets, trends are usually difficult to turn around, and in the past help from the central banks was needed to convince markets that a particular currency was ‘cheap’.
Others take a more cynical line, pointing to the rather poor record of central bank successes in the realm of intervention particularly over the last decade.
Lescure is critical of the European Central Bank’s (ECB) ability to communicate and give the world a unified view. He goes on, “It is so difficult for foreign investors to believe there is someone clearly in charge at the ECB. Investors need to feel assured that the Bank is working as a single determined unit, otherwise poor credibility will continue to haunt the Euro.”
Griffiths agrees that the ECB has a problem, and comments: “We think that the ECB has to weather a period of economic difficulties to earn its star. Five years ago, the Bundesbank was in charge and adulated for its timing, its control and its independence. Now, the independent Bank of England is gaining considerable respect from investors. It takes time. And for the ECB and the euro there is the small matter of having to consider 11 economies and 11 differing fiscal policies.” Griffiths ends by saying that central bank intervention has a much higher chance of succeeding if it is done when a currency is close to turning and values are very over-stretched: levels which, argues Griffiths the euro may be close to reaching.

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