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Fixed Income Market Reaction

24 June 2016 by Mark Holman

For many it will be a celebration today and for others it will certainly not have felt like a good morning at all.  Given that equity and currency markets tend to take the limelight on days like today, we thought we would share some of the action in the fixed income markets so far today.

When I walked into the office at 4.30am I knew by the glum faces that the news that the market did not want to hear was a reality. Cable was at 1.32 and the long US Treasury that trades all night was 20 bp lower in yield, a move upwards in price of 4% from where we left it, as we walked out last night. European government bond markets did not open until 7am and UK Gilts until 8am. In credit, our only gauges of risk at 4.30 were the credit spread indices; with the European high yield around 100bp wider.

To be honest , this was about what we expected, and there was a reasonable amount of risk changing hands in the market place.

By the time that Europe opened, the sovereign markets behaved according to their geography with the peripheral bonds going lower in price and the core going higher. At the open the moves were quite extreme with the longest dated bonds in the periphery down 5 or 6 points.

When the Gilt market opened, after Mark Carney had spoken, they opened with a very firm tone; with the ultra-long bonds up circa. 7 points, a move of around 5% in outright terms.

Since then as the morning wore on, and the news was digested, we suspect that there was coordinated intervention by Central Banks buying STG and during the course of the morning cable gradually appreciated rallying up to 1.39 at one point. We also suspect that the ECB was busy in its purchase programmes as, by the time of writing, peripheral sovereigns are almost unchanged on the day. As the ECB has to buy according to the capital key, they will also buy Bunds which now have negative yields all the way to the 2030 maturity. In fact the longest Bund, the 2.5% of 46, is up in price terms by nearly 10 points, a move of 7% …not bad for a bond with a yield of just 0.46%!

In credit there were really very few sellers of cash bonds and at the initial very cheap prices ‘indicated’ by dealers, which for UK £ high yield issues were around 5 to 7 points lower, we have seen virtually only buyers looking to pick up cheap risk. The UK bank sector, AT1 in particular, saw the most negative price action, but again we have seen no selling and only buying enquiries, and as with HY about half the initial indicated mark down has been recovered.

At this stage, it looks like the market is not overacting in the way that it might have done, indicating that investors had and have cash on hand to buy the dips.

Our conclusion so far is that financial markets had been under-pricing the risk of a Brexit for some time, even more so in the last week, which has served to make todays initial moves in the broader market indices more severe.

The consequences of  a Brexit on the UK economy at this stage are going to be hard to predict, but we believe that overall it will harm growth and result in a policy response from the Bank of England, with a rate cut to 0.25% at the next MPC meeting on July 14th.

Yield will therefore remain the market’s most scarce commodity over the medium term. However, in the near term, risk assets may well continue to be volatile with some drawdowns, but once the turmoil is over we think this will be relatively short lived.

At TwentyFour we had contemplated very seriously the not unlikely prospect of a vote to exit and consequently placed a number of hedges in the portfolios that we manage that allowed this . These hedges should help cushion the blow from today’s market volatility, but the portfolios are still likely to experience some drawdown before the end of the day.

For investors looking for yield in their portfolios generally we think the Brexit vote provides an attractive entry point to capture it.

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