Ever since the summer of 2013, when then-Federal Reserve chairman Ben Bernanke mooted the idea of ending quantitative easing, investors have focused on what happens when US interest rates finally rise. The end of a 35-year bond market rally?
The answer, though, might be: not much. Volatility is likely to spike, but in short-term increments; the persistence of low yields will linger, however.
“The European Central Bank and the Bank of Japan had followed the Fed’s lead, but now there’s divergence among the major central banks,” said Eric Stein, co-director of global fixed income at Eaton Vance Investment Managers in Boston.
This in itself will generate some volatility, but so will the end of the Fed’s QE programme, which both inflated asset prices and put a lid on volatility by steering investors into risk assets.
And, indeed, fixed-income markets have experienced sudden surprise movements. Last week’s action in the US Treasury market, which saw a 33 basis point drop in 10-year Treasuries in a matter of minutes on October 14, proved a dramatic example.
So have selloffs in emerging-market debt in 2013 – the so-called ‘taper tantrum’, caused by Bernanke’s airing the possibility of tapering the Fed’s $4.5 trillion asset-purchasing programme – and the July 2014 selloff in high yield, driven by jumpy retail investors.
The consensus ...
These mini-panics are notable for how they end: a return to something close to the status quo, as longer-term investors take advantage of cheaper prices to buy. The Treasury action is even more notable because it represented a spike in demand for safety: volatility cuts both ways.
The big-picture development that is roiling fixed income is the recovery of the US economy, which means the Fed will no longer provide so much, or any, liquidity. The easy money that has driven money to risk assets, from Mayfair flats to the S&P500 to high-yield bonds, is widely expected to decline.
The Fed won’t be buying long-dated Treasuries or mortgage-backed securities because it no longer needs to suppress interest rates to enable banks and households to pay down debt.
The currency markets have responded first, with the dollar appreciating against the euro and the yen (and against gold). The US may be climbing out of recession, but the rest of the developed world is not, and China’s growth story is decelerating.
The consensus trade today assumes the dollar will keep on strengthening, bolstered by a rise in US interest rates in 2015, the first such increase since 2006. Looking a little further ahead, the consensus assumes that US rates should return to “normal” levels, which for the 10-year means GDP growth rate plus inflation, or 3.5% to 4.0%.
... may be wrong
But the consensus has mostly failed to understand the post-crisis environment.
“People have been predicting rate hikes for five years now,” said Edward Qian, CIO at PanAgora Asset Management in Boston. But a poor recovery, lack of demand, deflation threats in Europe and Japan – all on top of US QE – yields have refused to rise. “Many investors have blind faith in rising inflation and therefore rising yields. People focus on yields too much.”
Diversification, including cash, is more important, he said.
The Fed is important, but it is not omnipotent. It is the world’s de facto central bank because of the size of the US' capital markets and the dollar’s unchallenged status as the reserve currency. That status is partly what’s behind the Fed’s problem these days: its inability to bend markets to its will.
The Treasury mania last week is a good example. Investors are worried about a global economic slowdown. They might be worried about geopolitical risks. Or they aren’t worried at all, they just have cash that must be put to work and their guidelines or regulatory frameworks insist they put a big chunk of their capital into very safe assets, ie, Treasuries. Or they work at the People’s Bank of China and other central banks that have outsourced monetary policy to the Fed.
To these buyers, be they US pension funds, European insurance companies, or Asian central bankers, whether the Fed raises rates next year is immaterial to their asset-allocation decision.
“We’re in an extended recovery, but animal spirits are absent and no one is building up excesses,” said Jim Caron, a fixed-income portfolio manager at Morgan Stanley Investment Management in New York. “Wages aren’t higher, lending is happening slower because the business cycle has been elongated. Investors’ focus is short term, but they need to be patient.”
Let's panic, shall we?
But, as Caron’s remark implies, investors aren’t patient. They want certainty and certainty, unlike money, is in short supply. So little frictions can blow up, and there exist plenty of flashpoints throughout the market.
Regulation has driven traditional broker-dealers to slash inventories and shy from making markets for investors. Meanwhile, retail has become a much bigger part of the bond market via mutual funds and exchange-traded funds, which promise daily liquidity; a promise that can be hard to keep in niche parts of fixed income. The distortions of global QE have layered the investment landscape with all manner of landmines.
Bond fund managers have responded by trying to become hedge funds without the fees. It’s now all about unconstrained, off-benchmark, absolute-return bets. This is partly to retain the possibility of alpha without resorting to undue leverage (which for most institutional investors is not allowed, although it is for high-net-worth money).
It is also a risk-mitigation tactic, to enable managers to diversify “conservative” portfolios into any available nook, from leveraged loans to junk bonds, using swaps to reduce rate, duration or credit risks, and to add currencies. Institutions are increasingly agreeing to looser mandates because AAA-rated bonds don’t deliver returns and, in the case of Europe, offer only negative returns.
“Portfolio resilience requires more imagination that just going short duration,” said Jeffrey Knight, global head of investment solutions at Columbia Management in Boston. “Absolute return becomes more important.”
Stay calm, actually
Is this risky? It is if you think US interest rates are about to enter a new era, and that everyone investing in spread products is overexposed. But as the Treasury mania last week demonstrated, US interest rates are almost certainly not going to do that.
“There’s been a lot of talk about bubbles, but I’m not so sure,” said Dominick DeAlto, head of global multi-sector fixed income at Fischer Francis Trees & Watts in New York. He notes that spreads in areas such as high yield are nowhere near historical lows, because their fundamentals are solid and demand is persistent.
Yes, a rate hike would force high yield and other spread sectors to adjust. But high yield, loans and emerging-market debt aren’t at risk of rising default rates for the foreseeable future. The risk is simply their relative attractiveness in a world of higher growth rates.
“Market participants have been expecting a rate hike for a few years,” said Richard Lindquist, a high-yield portfolio manager at Morgan Stanley Investment Management. “The rate hike, when it does materialise, won’t be dramatic given the weakness everywhere else.”
There’s no inflation in the economy to battle. And the Fed doesn’t operate in a vacuum. European and Japanese QE is just getting started. Big companies have vast cash piles that aren’t being put to work. Chinese liquidity is building and needs a constructive outlet. Technology, the digital disruption, is deflationary, cutting out middlemen right and left.
Last week James Bullard, president of the Federal Reserve of St. Louis, said the plan to completely end asset purchases this month should be postponed to December.
Demand for US Treasuries will continue to suppress yields. Any rate hike would represent a change in regime, but it wouldn’t yet represent a change in the global picture. The US cannot escape the rest of the world, so its recovery will be limited by the weakness of others. And the robustness of its employment numbers is questionable: Jim Walker of Dragonomics argues the US has not achieved any kind of growth in quality, well-paid jobs; he predicts the Fed won’t raise rates at all.
On the upside, the business cycle is not about to steer back to recession, either. It’s been a long expansion for the US, starting in 2009. In a normal cycle, the animal spirits should have gotten out of hand and it would be time for a recession.
But the distortions of QE, the persistence of pre-crisis levels of indebtedness (now on public, not private balance sheets) and the paucity of investment opportunities involving labour or capital means none of those excesses has occurred. The business cycle, at least in the US, is likely to maintain its mediocre pace.
All of these factors suggest that the Fed can raise the federal funds rate next year by 25bps, as the consensus expects, but they also suggest it won’t matter, at least not immediately.
“There’s a misplaced faith in the power of the Fed,” said Joe Ramos, portfolio manager at Lazard Asset Management in New York. “This market is run by the private sector. The bond vigilantes haven’t gone away, they’ve just been voting with the Fed.”
There will be volatile moments but the persistence of the bid makes a systemic, self-reinforcing panic unlikely. The consensus for several years has been that interest rates are so low, they must rise.
That’s changing to a consensus that says volatility has been so low, it must rise – but so far, each round of excitement ends without a fundamental change in bond-market dynamics. To do so would require a global economic expansion that just doesn’t appear to be on the cards.