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Special Report

Impact investing


Asset Allocation Fixed Income, Rates, Currencies: The big picture

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  • Short and long-term spreads: US vs euro-zone

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When the Fed embarked upon its first round of quantitative easing five years ago, there were fears of an inflation time bomb. The Fed has already purchased its last lot of Treasuries under QE3, but is still executing regular MBS purchases, as forward inflation expectations in the US and Europe are as low as they have been for years. 

The falling oil price is a strong influence on US current and future inflation figures. US shale oil supply is coming on-stream rapidly, and the US is now set to overtake Saudi Arabia’s oil production in the next few years. 

Saudi Arabia and OPEC have still not reacted to the lower oil price, although there are plenty of rumours, one being that Saudi Arabia is ‘happy’ to see the oil price falling, hoping that it will reach a level where it becomes uneconomic for US shale producers to extract, as these costs are at a higher level than for OPEC members.

Low, or falling, US inflation is not a cause for concern in the medium term as the economy remains buoyant. 

However in Japan, having moved back its target date to reach 2% inflation, the Bank of Japan is still expanding its balance sheet. Demand remains weak and there is a danger that inflation may be falling below the 1% mark.

The weaker euro will have mitigated some effects of the (dollar-denominated) fall in energy prices, and although shorter maturity inflation expectations have moved with the oil price, longer-dated expectations appear to have stabilised. However, with no cushion for complacency, inflation watching remains a high priority.


The spread between US Treasuries and Bunds has been rising in an almost straight line since the end of 2011, and is now approaching the highs reached in 1999. The trend in the Fed Funds-ECB refi spread, although increasing as the ECB remains in easing mode, has not risen as rapidly as the bond spread, suggesting that the bond markets have priced in a great deal more divergence than is evident at the moment. 

The long-awaited announcement from Japan’s JPY112trn (€782bn) Government Pension & Investment Fund (GPI) about its asset allocation plans managed to surprise, as the fund intends to switch even more than expected out of government bonds (JGBs) and into stocks and foreign assets. 

Short and long-term spreads: US vs euro-zone

Short and long-term spreads:US vs euro-zone

Given the magnitude of both the fund and the allocation shift – cutting government bond holdings from 60% to 35% – the fund will be a huge seller of JBGs. On paper, the BoJ’s new QQE programme ought to be able to absorb this, so the net effect on JGB yields is not clear. The yen may be more impacted.

After a shaky start, emerging market bonds have enjoyed a good 2014. Although a worry for Europe (and Japan), many emerging market bond markets have benefited from the global disinflationary environment, as their domestic CPI figures have trended lower. 

However, even though energy and food prices are forecast to fall further, the outlook for EM bonds is not bright. For some, lower CPI prints will not make a difference, inflation will stay above target, and central banks will remain hawkish. 

For other economies, the falls in domestic CPI may bring inflation within target. However, this could see some emerging market policy makers take advantage of central bank easing, or perhaps not raising rates, to hold back from their necessary, but painful, economic and social reforms. 


With inflation expectations remaining weak, the euro is set to remain weak against the dollar as the market waits for more (unconventional) easing from the ECB. While emerging market bond yields could be attractive, their currencies might continue to weaken in the face of more dovish central banks. 

The news of more QQE from the Bank of Japan (BoJ), coupled with the increased GPI foreign diversification, point to a weaker currency. Indeed, since 2009, USD/JPY has traded in line with the relative central bank balance sheets. The prospect of the Fed’s balance sheet no longer expanding, coupled with a massive increase in the size of the BoJ’s would seem to be supportive of a rising USD/JPY rate.

The Russian rouble has lately been one of the weakest currencies. Versus its dual currency basket (€0.45 and $0.55), the rouble dropped 8% in October and has lost about a fifth of its value since July when the Bank of Russia (CBR) last increased rates. It has been under pressure from falling oil prices and the conflict in Ukraine. 

As well as hiking rates, with a 150bps move in October, the CBR has been intervening to support the rouble, draining its foreign exchange reserves. The CBR has made clear its intention to move to inflation targeting. The weakening currency has already put upward pressure on inflation, which is already at 8% year-on-year, considerably above targets. With food import restrictions and further currency weakness, inflation will only rise further before the end of the year.

Focus: liquidity and volatility

The ‘taper tantrum’ in 2013, and the market swings of this October were both volatile episodes apparently erupting from the previous low-volatility trading, with asset prices everywhere gapping up and down dramatically. Trading volumes increased, as liquidity worsened. 

Trading liquidity in the capital markets, and its evaporation in times of stress, is much discussed. Although there is agreement that liquidity conditions have deteriorated since the financial crisis, there is no consensus as to the cause. 

In the US, banks’ trading desks argue that Basel III and other post-crisis regulations, such as increasing reserve requirements and the Volcker Rule limiting proprietary trading, are to blame for the inability to absorb excess supply or demand. 

Fed research into the role of dealers in Treasury sell-offs, on the other hand, suggests that attitudes have changed, and their own risk aversion ‘biases’ were holding them back from active market-making and risk-taking. In one analysis, the Fed concludes that the increase in yields (during the 2013 ‘taper tantrum’) was “likely caused by a broad repricing of duration risk, and not by regulatory constraints”.

Although government bond market liquidity has shown signs of drying up – most notably in Europe as tensions associated with the sovereign crisis have resurfaced – there is more concern about corporate bonds and other credit. With little standardisation in corporate bonds, and huge issuance over the past few years, liquidity worries are growing.

Although many investors, can and have, resorted to derivatives, others must rely on the cash market. In the run-up to year-end, often a time for book tidying, daily trading will further diminish. Everyone will be hoping that markets are not assailed by more macro or geopolitical shocks.  

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