Yields Higher, Time to Act?
15 November 2016 by Mark Holman
The last week has seen sharp moves in the world’s risk free rates driven by sentiment from across the Atlantic that the new Trump administration will initiate a large fiscal stimulus plan that will spur growth at the expense of inflation. A similar sentiment has been hanging over the gilt market, as participants anticipate the content of next week’s autumn statement by the new Chancellor.
The market’s initial conclusions in both cases are: bullish for growth, bearish on rates and bullish for credit spreads.
It is hard to argue with this conclusion, although the move seen over the past week has been quite extreme. Where this move will end is hard to predict at the moment, as we have lived in a world where ultra loose monetary policy has buoyed asset prices and kept the world’s risk free rate low. Now if we have a regime change, and the focus moves to a more conventional route of monetary stimulus, where do yield curves move to…and more to the point, where can we invest in fixed income without having too much exposure to getting this decision right or wrong?
US Treasuries have stolen the limelight over the past week with the 30-year bond breaching the 3 % mark yesterday for the first time since the start of the year. The move is up almost 100bps from the morning after the UK referendum vote and 30bps since the morning of the US presidential election. In the UK, gilts are only just back at levels prior to Brexit, and we are staring at inflation of 3-4%, that we know will come our way in the next 12 months. Meanwhile, US inflation is merely market expectation of Trump’s policies that might be enacted. We could write many paragraphs on why these yields may have risen too much, or may still have further to go, but let’s keep it short and focus on where we can invest while this uncertainty hangs over us.
I would conclude the discussion on the recent rate moves as a situation that we have to watch very closely but not commit to until there is more clarity. When rates become a source of risk the moves can be violent but they do not tend to last too long; although exceptions do occur such as in 1994 when the move upwards in risk free lasted from February until November, followed by a huge rally back in 1995. However, I am not comparing today’s situation with then, I am merely looking at timeframes. Bernanke’s taper tantrum lasted from May until September 2013, following the more normal relatively short-term moves within the risk free sector. The opportunity for a rally in the aftermath is a good one though, so we must and will pay close attention.
In the meantime, we should invest in areas that have less sensitivity to this upward move in risk free. We should also not forget that the policies being discussed should be constructive for credit, although we must acknowledge that ultimately uncontrolled growth does increase the risk of the economic cycle ending badly. In our view though it is too early to be talking about that.
Sectors such as banking or infrastructure are most likely to benefit from these transitional periods, but given the very high correlations in fixed income, this is just tactics. Strategically, focussing on higher yield and lower duration has to give the most opportunity during these periods of transition. Floating rate notes were the best fixed income assets to have in 1994 as credit spreads tightened and their complete lack of rate sensitivity pushed prices higher; European CLO’s might be a good example. BB-rated Euro notes yield around 600 over Libor. However, the FRN market is small and hard to express ones preferences accurately, so although not quite as good, short duration bonds with plenty of credit spread to absorb the move up in risk free curves are a good second choice. Old bank hybrids, that the banks are retiring as they no longer function as required under new capital regimes, are as good a way of playing this as I can think of; many are high BB or BBB-rated and yield 4-5% and remain well sought after and in short supply.
We should also think about yield curve shapes and how these may change as a consequence of policy change. Inflation hits the long end most, however policy makers primarily decide short rates. In the US the inflation that may come through as a result of expansionary fiscal policy, is the “wrong sort of inflation” and therefore the Fed will be more inclined to act. In the UK, the inflation that we know is coming is more transitory, so the BoE is expected to remain on hold. Accordingly, the front end of £ and € curves may well be safest in the short term; although again we would acknowledge that the market is likely to overshoot in $ curves in fear of Fed action.
A short mention must also go to cash, which is not a strategy, but will be a short-term requirement in order to have the flexibility to get back into rates products when the recent upward move in yield has peaked.
In short, it does not feel time yet to add additional risk, and our focus remains on shorter dated bonds and floating rate bonds with plenty of yield. However, the sharp upward movement in rates products is interesting to observe as it could provide a good opportunity down the line.
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