Orders for durable goods made in the US fell by 1.4% in February, confounding market forecasters who were expecting a rise of 0.2%. Coming as it does, a week after the March FOMC meeting, during which Fed chair, Janet Yellen poured some cool water on expectations of an imminent rate rise in the US, the data serves to further underline such expectations.
With expectations as to the timing of the first US rate pushed out and a growing belief that a rate hike this year in the UK is unlikely, so the looming spectre of policy divergence gets pushed out too, replaced with a recognition of just how full the global liquidity sink is. And, importantly, how this monetary damp is warping, not only current markets, but also their future reaction functions.
This is perhaps most notable in the fixed income market where yields are at historic lows and continuing to fall. And, there is little way to know exactly how yields are going to react to increased rates, especially as they continue to get pushed out.
Kerry Craig, global market strategist at JP Morgan Asset Management points out that, while historically the fixed income market should be the area most affected by a central bank raising rates, the massive monetary stimulus seen since the crisis makes history an unreliable guide.
And, he adds: this unpredictability is exacerbated by expectations of eventual policy divergence.
“The yield curve can be split into the short end and the long end, or two-year and 10-year maturities. The short end is much more in tune with central bank policy and sensitive to rate moves, while the long end has become more international and influenced by global trends,” He says.
Nick Hayes, manager of the AXA WF Global Strategic Bonds Fund, agrees that past performance is becoming less useful.
As he points out: “Increasingly fixed income valuations are being distorted by the supply demand dynamic skewed towards lower yield, in some cases lowest yield ever which goes back to 500 years of historic data! 2014 saw a combination of the market lowering expectation of where the peak in interest rate cycle would be, but also a strong consensual positioning of being short duration which was painful as yields rallied, and led to further buying as investors closed underweight positions.”
For Hayes, recent market moves can be likened to the ‘capitulation phase’ of the technology bubble.
“it’s the phase that says “maybe I should just buy these IPO’s because they always seem to go up, even if the economic fundamentals are poor”.
This phase is important because, unlike in 2014, where the broad consensus deceision to be short duration meant everyone was facing the same way, the market is now much more balanced
“As such, like the Nasdaq in 2000, maybe the market will just fall in on itself and rising yields will be met with little resistance.
As a result of this view, Hayes, continues to prefer bonds of shorter maturity, he also likes US high yield.
But, he adds, as a caveat: “when the overall reference valuation point (US treasuries) for all fixed income is ‘expensive’, I believe that it’s fair to assume a re-pricing of US treasuries, and other core government bonds, could lead to a selloff in most of the asset class.”
“For me 2015 should be about “Yield give up” not “yield pickup”. Over the last five years investors have been rewarded well for ‘hunting for yield’ in fixed income… In 2015 I’m looking to buy the lowest yielding assets, that importantly are also carrying a low level of risk.”
For Craig the current positioning is slightly different.
“If shorter-dated maturities start to rise on the back of higher policy rates, the yield curve will flatten as the longer end rises by less. This particular combination is known as “bear market flattening” of the yield curve and the short- and long-term rates start to converge.”
However, he says, this is unlikely to go on forever as the growth implications of this would be something the Fed will look to avoid.
A tightening of monetary policy, Craig says, will extend beyond just government debt and could negatively affect both investment-grade and high-yield corporate debt. While, for the riskier high yield, an upward move in interest rates should be taken as a sign of an improving economy.
But, he adds: “For bond investors, a move to higher rates may not be the calamity once feared since the excessive demand created by central bank policies will continue to support fixed income markets. However, given the very low yields on offer across the fixed income spectrum, it will be more important than ever to take a selective approach when allocating to different fixed income positions.”
