Before the most recent iteration of the Greek/eurozone drama and the Chinese stock market drop at the end of the second quarter, the emerging narrative was that bonds were finally experiencing the losses that many had been predicting for years. Dramatic headlines proclaimed the demise of the bond. Examples included a May 13th commentary headline in The Telegraph that blared “Worst bond crash in almost 30 years” and a June 3rd Bloomberg headline “[European Central Bank President Mario] Draghi Says Volatility Here to Stay as Global Bond Rout Deepens.” The Telegraph article highlighted “losses over the past three months have reached $1.2 trillion.” The magnitude of these numbers is somewhat shocking until put into the context that the total value of global bond markets is in the vicinity of $45 trillion. The ‘rout’ then is still short of a 3% decline.
Though headlines have been deceptive, it is fair to observe there has been a meaningful move in bond and U.S. Treasuries in particular. From the January 30th low point of 1.64% for 10-year Treasury yields, rates rose over 50% to a high of 2.48% on June 10th before closing the quarter at 2.35%. Though only an 18 basis point move from year-end, the over 80 basis point range for trading represents meaningful volatility against the beginning of the year’s starting point.
How did we get there?
The increase in U.S. Treasury and global bond yields in the second quarter corresponded with an increase off of all-time lows in German yields from a closing yield of 0.075% on April 20. At one point, €2.8 trillion out of the approximately €5 trillion eurozone government-bond market was trading with negative yields according to Bank of America Merrill Lynch. Other second quarter oddities included three-month Euribor (euro interbank offered rate), the rate at which banks in Europe lend to each other, falling into negative territory and Spain issuing three-month bills with negative yields, which represented a remarkable contrast to 2011 when it was considered to be at risk of losing access to debt markets.
Negative yields are a somewhat mind-bending concept. While partially explainable in the context of deflation, the explanation is incomplete as cash would offer a better real return in a deflationary environment. Growth expectations were extremely low and inflation expectations were negative, which drove some element of the downward pressure on yields. The larger factor, though, was the quantitative easing (QE) program by the European Central Bank (ECB). With the proverbial 800-pound (360 kilogram) gorilla in the room conducting €60 billion of monthly purchases designed to push down interest rates in Europe, the anticipation of ECB purchases drove yields below 0%.
The second quarter was filled with unusual and somewhat contradictory events in global markets: all-time lows for German Bunds, followed by an increase of yields by an order of magnitude; a new step forward in European integration – the ECB’s QE program, once considered off-limits – paired with increased speculation on the exit of a member country from the common currency.
The July 5th Greek referendum on the creditor terms of the proposed bailout resulted in a resounding “no” from the Greek populace. While a new round of bailouts appears to have been agreed upon, the solution is likely temporary and the political brinksmanship from both sides brought the potential exit of Greece from the eurozone close to reality. The exit of a member state would undermine the famous 2012 promise of Mario Draghi that “the ECB is ready to do whatever it takes to preserve the euro… believe me, it will be enough.” Fiat currency, being backed by nothing but the creditability of the issuer, faces a significant challenge when uncertainty is introduced.
Further, to the extent that risk premia rise in Europe, the cost of capital in Europe will be higher, offsetting some of the benefit of the ECB’s extraordinary efforts to improve the real economy via monetary policy. The Greek situation continues to develop at the time of writing, though given past iterations of eurozone crises, this may be true no matter when a piece is written.
Recent sharp declines in Chinese equity markets of over 25% after a doubling over the past year may represent more of a challenge globally than turbulence out of Greece. Often viewed as the marginal buyer of commodities, the fall in Chinese equities and perception of a slowing economy have already impacted oil markets. The last decline in oil in the second half of 2014 had broader implications for volatility and was highly correlated with an increase in U.S. credit spreads. In response to a slowing economy and the recent fall in equity markets, the People’s Bank of China (PBOC) has cut interest rates four times since November, joining the group of global central banks easing monetary policy.
Though the Bank of Japan (BOJ) and now the ECB are attempting to create their own versions of the American central bank policy, not all QE is created equal. There are enough differences in the programs and the regions to suggest they will play out differently. The Fed’s version of QE aims (it hasn’t unwound yet) to keep interest rates low in the U.S. to support interest rate sensitive areas of the economy and change the risk/reward equation in investors’ minds, shifting them to more risk seeking activity. In the United States, equity ownership is ingrained in the culture. By contrast, Europe is generally considered a ‘debt culture’. While the U.S. QE was designed as a change in degree, the European version is designed as a change in kind. Draghi’s goals were far more ambitious than Bernanke’s and now Yellen’s. Draghi is looking for QE to provide the cover for European countries to engage in the painful structural reform to be more competitive in global economies. Abenomics, which has professed similarly ambitious aims, has yet to noticeably transform Japanese culture, suggesting the 19-month ECB plan may face difficulties in its larger goals, even if some of the growth and inflation targets are reached.
In the second quarter, as European deflation fears receded and European growth improved, European interest rates began to rise. In part, Europe’s growth benefited from euro weakening, while the U.S. experienced a negative first quarter of GDP growth (-0.2%), partly due to the dollar strengthening. At this nascent stage of the ECB’s program, it is premature to judge the outcome on yields, but even more so it is certainly too early to judge the outcome of structural reform. If the events in Greece are any indication, the painful restructuring may be more painful than hoped for.
While Europe and Japan struggle with the use of monetary policy to impact significant structural and cultural changes, the discussion in the U.S. remains around when the Fed may raise the fed funds rate. Janet Yellen said at a March 27, 2015 conference that “the economy’s equilibrium real federal funds rate—that is, the real rate consistent with the economy achieving maximum employment and price stability over the medium term—is currently quite low by historical standards.” We view the Fed as likely to take a “risk management approach” to monetary policy—erring on the side of being accommodative, as they view their tools for fighting inflation as more potent than their equivalent tools for fighting a recession. That this year’s increase in long U.S. Treasury yields has had little impact on short rates seems to show that the market is currently viewing the Fed as patient as well.
Relying on mean-reversion heuristics, as market pundits have done since the end of the recession, has led to spurious conclusions such as declaring bonds dead… over and over and over again. The current global economic environment—where trillions of dollars are necessary to keep economies afloat, a major global currency’s viability is questioned, a significant emerging market attempts to manage its own ‘soft landing’ while simultaneously being the driving force behind global commodity prices, developed nations demographics impede growth and innovation rather than spur it—is not one where interest rates can afford to quickly “normalize” to historical levels. A different heuristic may be better suited than mean-reversion for projecting the markets: don’t fight the Fed… and the ECB and the BOJ.
While a seeming strengthening European economy pulled global yields higher, the possible exit of Greece from the eurozone reminded investors of the role of fixed income as a defensive asset in a diversified portfolio. Credit widening at the same time as increasing yields in the second quarter have created an opportunity within investment grade fixed income for overall yields not seen in some time. Credit curves seem too steep in our estimation, which presents an opportunity within fixed income. The recent volatility has also left dislocations in its wake, presenting further opportunities for security selection.
Interest rates / duration: Expect continued rate volatility; remain neutral and barbelled; current term structure reflects slower expected pace of Fed rate hikes and lower terminal point for hikes
Treasuries: Underweight, favoring non-government sectors instead; favor nominal Treasuries over inflation-hedged Treasuries (TIPS)
Credit: Spread curves appear too steep, particularly in industrials, which presents attractive total return opportunities; U.S. credit should benefit from relative U.S. strength, global uncertainty, yet higher yields in U.S. versus other developed markets
Mortgages: Liquidity profile remains attractive for Agency mortgage-backed-securities (MBS), especially as liquidity has declined in other sectors. Sector should be supported by limited supply of new issuance, but offers limited total return expectations
High yield (HY) and emerging markets (EM): Select bottom-up opportunities persist in HY, but macro concerns and valuations temper outlook; current yield advantage of EM appropriately compensates investors for the risk
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