From possible rate hikes, to open discussions about the possibilities of rate cuts, it is little wonder that market volatility remains so painfully high. Whilst many fixed income managers are bemoaning the fact that their portfolios are not long enough against respective benchmarks, it could be worse: they could be equity fund managers. That said, unless those benchmarks have been government-only, then times are still very difficult as credit spreads have widened enormously.
“Bond markets are taking their cue from equity markets and the link is total. We all know that this huge rally in bond prices is about a ‘flight-to-quality’,” says Commerz Asset Management’s Martina Kocksch. “And it’s been a tough time for absolutely everything outside the government markets. And yes, I would admit that I am irritated that we are not positioned greatly long of our government benchmarks. That said, I think it is more prudent to stay quite close to your benchmarks in these uncertain times.”
Kocksch points to the slew of recent data from the US that paints a very blurred picture of the economic realities within it. “We had been running longer portfolios but, at the beginning of June we were seeing positive economic numbers coming out of the US. We thought that short duration as a reaction to these numbers would be appropriate. And then equity markets started to tumble. And that’s when government bonds started taking off, and credit spreads started to widen. No-one wants it (corporate paper) on their books right now, it’s government or nothing.”
“Credit markets have been hit incredibly hard,” agrees Insinger’s Alexander van der Speld, “to levels that, in the cold light of day, do look really cheap. We sold out much of our credit positions within our government-benchmarked portfolios at the end of May because we had seen significant spread tightening since the start of the year and we just had a nasty feeling that this particular party could not go on. Although we were correct to do this possibly for fundamental reasons, we did not go long duration – we had no idea that that the yield on the 10 year (US Treasury) would hit 4.20%.”
So do investors believe that the Federal Reserve will cut rates in the near future? “I believe that if this near-panic situation continues then it is possible that the Fed will cut rates,” says Kocksch, “And given how equity markets have already fallen, I think that the Fed will surely resist raising rates until later. In sum, I don’t think we will see any changes this year from either the Fed or the ECB.”
There are certainly rumours swirling around the market that the Fed will cut rates at its next meeting in mid-August, comments van der Speld who believes that they are indeed only rumours and not backed up by much fact. “Yield curves are very steep right now – a move that we missed out on as we sold twos to fives and moved into cash. We were waiting for the anticipated flattening to happen as the economy starter to recover a bit both here in Europe and in the US, but subsequent events have seen that part of the curve drive further downwards.”
For both Commerz Asset Managers and Insinger, the recent volatility and yield moves have raised the stakes in Latin America and new risks could be emerging. Kocksch explains, “First, Argentina took the headlines, and now it’s Brazil with its new government who don’t seem quite so keen to please the IMF. There is also some serious trouble brewing in Uruguay who have just announced a banking ‘holiday’. This could all turn nasty, with currencies coming under pressure and we do need to listen and watch this area.”
“I agree,” says van der Speld. “Capital markets have not seen extremes like this for a long, long time. Look at Brazil – have the IMF drawn their lines in the sand by backing Uruguay with a loan? Uruguay is squeezed in between the troubled countries of Brazil and Argentina There is a chance that it could all spill over to the other emerging markets – to Russia? Poland? Further west perhaps?”
It is not only in the ‘flaky’ emerging markets that van der Speld sees the potential for things to get considerably worse. He explains: “With spreads this high, and there not appearing to be much scope, in the near term at least, for them to narrow it is becoming more and more difficult for corporates to refinance their outstanding debt.
“Consider some household names, like Ford or General Motors seeking to find alternatives to their existing commercial paper and certificates of deposit programmes. They can try and issue long dated bonds, but it would be so expensive, even for them. Couple this with liquidity continuing to dry up in maturities up to 12-months as investor appetites evaporate and it is not hard to imagine credit ratings starting to come under pressure.”
Van der Speld goes on to raise the spectre of more and more companies slipping below the A-/BBB line. Although we may be some way off this vision of a mass decline of outstanding debt down into sub-investment grade, as certainly the top names still have relatively easy access to liquidity Van Der Speld is not alone in his thinking. And in this tense atmosphere, it would not take much to trigger another bout of credit widening, getting us ever closer to that vicious circle of mass decline to junk status.