Domestic Bond Market
Since the month of May and Bernanke’s hint that monetary policy may become less easy than in the post Great Recession years, the bond market has been in a relentless rout. In all honesty, bond holders didn’t have to wait for the FED Chief’s remarks as the risk reward ratio in fixed income was rather lopsided to the negative at the end of Q1. Accordingly, at THALASSA, we reduced risk and in some cases introduce interest rates hedges. But this was then and now here we are after an approximate 10% correction in the 10 year US Treasuries with yields backing up to 2.82%; is the bond rout over?
We think the move so far has stressed a clear long term reversal in bonds and while short term volatility will move the asset class in both directions, it seems to us that this trend will have long legs. Research from JP Morgan looked at past cycles and Fixed Income corrections did not stop until the end of monetary tightening was near; at this juncture, monetary tightening has not even started! Another signal in the past has been a reversion of real yields to value levels – historically around real yields of 3% - which would imply a 5% handle on nominal 10 years – a doubling of current nominal yields.
What is interesting to note, is that the speed of the correction seems to be rather disconnected from economic data which have been mixed recently. This factor indicates that much of the selling is driven by longer term re-allocation of funds away from fixed income. Statistics on money flow would seem to confirm this thesis and anecdotally, Bill Gross’ plea to his investors in his latest Investment Outlook to stick with PIMCO would again seem to validate the re-allocation dynamic.
At this point, all eyes are pointed to the FOMC meeting scheduled for September 17th and 18th; The FED is expected to release its 2016 forecasts for unemployment and inflation which consensus projects them to be at neutral levels. JP Morgan research sees a potential conflict for the FED as matching monetary policy (neutral) should see rates at 4%; however, if the FOMC communique were to project 4% funds rates by 2016, the bond market would probably react with a big sell-off. The FED could indicate rate forecast for 2016 of “only” 2.5% in order to hold the market’s hand during this policy transition. Rate Forwards for 2016 are indicating levels around 2.2%.
Two additional elements of interest in this bond correction are the significant rise in money market yields and the widening of credit spreads. As for the latter element, spreads usually compress when Treasury yields rise. JP Morgan interprets this dynamic as credit having been at the “true center” of the search for yield trade. We are inclined to agree and we see the widening spreads as confirmation of the general trend away from fixed income.
Emerging Markets Bonds
A collateral victim of the FED pre-announced and imminent change of policy was the EM bond market. Emerging Markets bonds were sold off even more aggressively than domestic paper as they got caught in a mix of behavioral panic, leveraged bets and confusing macro data.
Interestingly, on the sovereign front – still the majority of the EM fixed income market – long positions were built since 2008 on the premise that credit risk for EM countries was actually better than DM (Developed Markets) and yet yields were higher. Such thesis did not help cushion the surge of volatility that hit EM bonds as the FED announced a change of pace. However, the balance sheets of some EM countries are indeed much better than in the past therefore local monetary responses to macro data and liquidity issues could be radically different than in other corrections.
Investors also seem to have responded to macro data indicating slowing economies. While, this is clearly a negative for equities, for the bond market it may play differently. Given the above mentioned degree of health for EM countries’ balance sheets, local Central Banks and governments could respond aggressively to the down cycle; this would translate in better bond prices.
In other words, there seems to be a short term disconnect between global yields correlations, countries balance sheets, and long term relative growth rates. Short term dislocations may start to uncover longer term value. PIMCO research quotes the example of Brazilian bonds (which incidentally we are starting to like alongside Mexican paper). Brazil is one of the few countries which is hiking rates; this is a counter-measure against inflationary pressures pushing the upper limit of their acceptable range of 2.5% to 6.5%. The Brazilian Central Bank has increased rates YTD from 7.25% to 8.5% and Forwards are projecting a rise to 10.68% by the end of 2014. However, the Brazilian economy is slowing down fast, among other reasons thanks to its commercial links to another slowing giant, China. As a result of this economic stagnation, rates may not rise further. PIMCO indicates Brazilian 10 year Sovereigns yielding around 11.4% in local currency terms. This is a spread of over 800 points versus the correspondent 10 Year US Treasury, giving the trade a decent cushion for the inherent currency risk.
An additional interesting element that seems to corroborate the technical aspect of the EM bond sell-off is what transpires from some of the money flow data: popular long positions in foreign accounts were sold more aggressively than long positions more popular with domestic investors (source: PIMCO).
Conclusions
The future of the bond market will look very different than its past. Investors will have to get adjusted to a more active approach and to a higher degree of selectivity. Successful investors will have to learn to incorporate volatility and currency dynamics, as well as hedging techniques.