Volatility at the short end
Although the European Central Bank (ECB) may not have changed official interest rates since the half-point cut back in June 2003, that does not mean to imply interest rates at the short end have also remained unchanged. TheECB may be controlling and setting the very short-term rate - via its main refinancing operations or refi rate and the other two rates, the marginal lending (which forms the ceiling) and the deposit rate (which defines the floor) - but it is ‘the market’ which prices the rest of the maturities.
“And it is not surprising to see volatility in the short end,” states Clariden’s Martin Hueppi. “It is the norm. The short end must react to news and be more sensitive. For long-term rates, it is the long term outlook on inflation that matters, and, if the markets believe that inflation is not a serious problem for the future - as seems to be the case in both the US and Europe - then long-term rates remain far more constant. But if we take duration (the price sensitivity of an instrument to changes in interest rates) into account then the price actions at the short end are, of course, much less significant.” Hueppi points out that market expectations of what the ECB was going to do have been wrong for many months and expectations of interest rate hikes from the ECB have been repeatedly moved back.
While it may have been a rather extreme situation in Europe, with such low interest rates and no change at all for almost two-years, it seems that markets often have a tendency to price in more rises than actually materialise. According to Merrill Lynch Strategists, interest rate forwards have consistently ‘predicted’ a significantly larger increase in interest rates than subsequently realised. Their conclusion states: “In three-month Euribor futures we observe that the bias has been positive (an over-prediction of rates) 70% of the time in the last 11 years.”
Of course, futures markets and forecasters do not always over-estimate the future. The oil market has been doing the opposite to the money market with its forecasts of falls in the oil price for the past two and a half years. At the moment the market has given up predicting a fall in the oil price and is pointing to oil (in terms of Brent Crude) staying up around $55 a barrel.
In Europe there seems to have been even more volatility than ‘normal’ over the past few weeks, reflecting a significant change in investor perceptions, despite immobility of the ECB’s monetary stance. “There has not been much activity by the ECB over the last 23 months,” says Robeco Asset Management’s Peter Wijn. “The ECB drives the three-month rate, but beyond that rates are driven by what investor perceptions of the central bank’s future rate decisions will be.”
Wijn continues: “We have two decisions to make when we are investing. We need to decide which duration is optimal. Our usual portfolio duration is around three-months. We do not deal a lot in cash instruments. The money market liquidity is very low: while you can easily get a tight bid/ask spread on a E100m Bund position, the same could not be said on a 17-day E3.7m Euro Commercial Paper (ECP) quote, for example. The bid/ask spread is relatively wide and the loss of yield covering that spread makes dealing prohibitively expensive.”
So what money market managers like Wijn do is keep their physical investments/holdings stable and then use futures to get the required duration. Wijn explains: “There is plenty of liquidity in the money market futures and we can quickly and cheaply get our positions in place. And, because we use this overlay approach, it means we can invest in money market futures wherever there’s the liquidity so we are not confined to investing in just the Euro-zone.”
It is futures on three-month euro interest rates (EURIBOR) which Robeco and other investors utilise. “For the Notional 10-year Bund future, it does not really matter which expiration month contract you use, although for best liquidity most use the on-the-run issue. However, for money market managers it does make a difference whether we use a three-month or a six-month future expiring in three or six months’ time and that is how we get our views to work,” says Wijn.
Robeco also invests in floating rate notes (FRN) which, by definition, have their coupons regularly re-fixed. “FRNs have short durations and thus low interest rates and because their coupons are re-set, we keep pace with the market. If we were invested solely in three-month ECP, for example, you could imagine that our annual portfolio turnover would be very high, perhaps 400%. And sometimes it can be quite difficult finding the right piece of paper to suit one’s exact investment needs.”
Wijn goes on to point out that, although FRNs may have money market-like durations, their credit spreads are higher. “We are, in effect, leveraging on our credit exposure by using an FRN. As the FRN has a longer maturity than ECPs it therefore has a higher credit spread. Usually our credit outlook for a corporate is fairly similar over three months or two years. As well as duration, the credit outlook is also important for our investment decisions.”
Reviewing the markets over the last few months, it seems that investors have been fairly successful at predicting the course of short-term interest rates in the US. “It has been pretty clear for some time what the US Federal Reserve would be doing as they have signalled their policy clearly and we have known that hikes would be ongoing,” says Hueppi. “In terms of what we have been doing at the short end in the US, we have been trying to ‘ride the wave’ and always be ready to take advantage of the higher rates when they occurred. Exaggerated expectations (of future interest rates) are usually good opportunities to invest and to profit from the higher rates. We always have new money ready to put to work quickly.” Wijn comments: “We have had a short duration position in the US until about a month ago, which is pretty much the right thing to be doing, as we were right in our predictions that the Fed would just keep on hiking more than the market anticipated. Currently we are duration neutral in the US.
“At the moment we need more clues in from the US economy to be able to predict what the Fed might be planning,” continues Wijn. “It is hard to ascertain just how worried the Fed is about the combined threat of inflation and slow growth. We know for sure that the Fed will be looking at the labour market data, and this could give us further clues.”
As for Europe, it’s been rather more tricky. “One or two months ago there was a big bear steepening as interest rates in Europe went up,” says Wijn, “but we did not perceive that inflation was a problem in the Euro-zone and so would not expect the ECB to be raising rates. However, we did not go long, because we were not sure enough and in the money markets you have to act when the market is ready to see the inflation risk fade away. We cannot afford to sit with a wrong position. The ECB could lower rates but the markets will need more convincing and time to get used to that idea so we are not going to go long just yet. We cannot afford to take more risk with no extra return.”
Hueppi says: “At the short end, investors really need to take account of what is already priced in. If, as is the case in Europe just now, there is no view of rates going down then this is not the time for us to go long. The three-month to two-year spread is not wide just now. Is one paid to take extra risk? Not at the moment, so if one does not have a very strong view then it really is best to stay put. Once we know what the ECB is up to then this fog of uncertainty will be lifted and then we make our move.”
Both Europe’s economy and the ECB’s mandate are very different to the US, argues Hueppi. “The Fed has a two tier approach to its monetary task, namely inflation and the state of the economy. The ECB, on the other hand, just has inflation. There are so many uncertainties in the economy, and the economic performances of the big economies should be a real worry. Germany’s restructuring moves, though a start in the right direction, are not enough and with an election on the way it is unlikely that any tough or painful decisions will be taken. Although some economies could withstand higher rates, like Spain for example, for Germany or Italy they could be far more damaging. The economic uncertainties are really big and the ECB needs to be more aware of the economic issues.”