Although August is traditionally the quiet month for bond and currency markets, at least in terms of trade volumes, the diminished liquidity often heightens sensitvities and volatility is often quite high. After the wild sentiment swings of recent months, the lull in July seems to have ended.
The Bank of Japan has been busy, and in raising the overnight rate by 0.25% to 0.25% has ended 18-months of the ZIRP, the Zero Interest Rate Policy. In fact this is the first rate hike in a decade. Investors were slightly less than impressed, and seem at rather a loss to explain the BoJ’s action. The managers at Cordius Asset Management in Brussels comments: “Despite the weak macro-economic situation in Japan, the BoJ raised rates anyway. We believe this action to be more a reflection of a gesture of independence for the BoJ, rather than the certainty of a sustainable economic recovery. Indeed inflation is still negative and consumption static in an economy where consumption represents 60% of GDP.” Cordius is pretty certain that there will be no further increases in rates and doubt that this hike will cause much of an impact in Japanese Government Bonds (JGBs). “Yes, the increase in bond issuance, caused by the economy slowing again, would put upward pressure on interest rates but we believe that the extra supply will be easily absorbed by the domestic buyers anyway” they argue, “So interest rates will not rise substantially”.
The Federal Reserve chairman has also been busy over the past few weeks telling the politicians, and markets what state he believes the US economy to be in. US Treasury yields had recently reached their lows of the year as the ‘soft landing’ consensus has gained in size. John Looby, fixed income fund manager with Canada Life’s Setanta Asset Management, is a firm believer in the abilities of chairman Greenspan. He goes on: “The US economy is slowing down already. I think the Fed has got the right level of interest rates to bring about this soft landing we have been wanting to see. Crucial to this outcome has been the action of the stock market. As it has gone effectively sideways for the past six months, it has been acting like a separate macro influence in itself. Imagine what would have happened if the stock market had continued to rise another 25%. All bets would have been off and the consumer, feeling a great deal wealthier, would have just gone off shopping again. And I think the Treasury market is well priced for this outcome, there is certainly no extra value to go for out to the 7/8 year area and maybe even the 10-year is reflecting reality.”
Vincent Hamelinck, head of fixed income at Cordius agrees that the Fed is ahead of the curve at the moment, but does not agree with Looby’s sanguine outlook for US Treasuries. He explains: “We have an underweight position in US bonds because we reckon the markets have reacted too optimistically to the weak growth and inflation figures. We do agree that recent economic data points to a gradual slowing of growth and confirms the ‘soft landing’ scenario. However, we think that upward pressure on wages and the high oil price will lead to an inflation rate that is higher than the consensus forecast.” Cordius expects a rate hike in November, which is not priced into the front end of the curve. Furthermore they think that any upward surprises on the inflation front would damage the medium dated bonds. They conclude that the long end of the curve is the safest place
Long bonds are also Setanta’s favoured instruments. Looby explains: “The possibility that the US budget deficit could be retired in 12-13 years’ time is a major, major event and quite unprecedented in our time. I think that the effect will be much more profound and longer lasting than the market currently believes. The curve is about 20/25 basis points inverted between the 10’s and 30’s and I just feel that it should already be much more.”
Cordius believes that European bonds offer better value over the next 3-months. Hamelinck explains: “We think that the European markets are correctly pricing in another 25 to 50bps of rate hikes, but that US Treasuries are ignoring the inflation risks which lie ahead. We are forecasting that rising interest rates in the US will cause the 10-year Treasury/Bund spread to widen out to 80bps.” Hamelinck believes that the German market is fully priced, but argues that curves in those countries where telecom licenses still have to be auctioned should have scope to flatten further. He suggests that the long end of the Bund/European curve is still interesting, and is overweight Belgium, Italy and Spain while underweighting the Netherlands, Ireland and Portugal.