AXA’s Iggo comments on bond markets

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Chris Iggo (pictured), CIO and head of Fixed Income Europe & Asia at AXA Investment Managers comments on the latest challenges for global bond markets.

The expected divergence of monetary policy between the US and the euro area is likely to become more concrete as we approach 2015. The European Central Bank (ECB) announced a form of quantitative easing (QE) and credit easing this week, pledging to expand its balance sheet through the purchase of asset backed securities and thus giving banks the opportunity to make new loans to the private sector. The euro has weakened and this should provide some relief to the euro economy. Elsewhere markets are focussed on the US labour market data and any signs that the Yellen doctrine of waiting to see the whites of inflation’s eyes before tightening is starting to crack. US short term yields are likely to move much higher relative to European rates in the next quarter or so. This is likely to push the euro to multi year lows against the dollar.        

 Back to school  –September is an interesting month. It is, of course, the start of Autumn, a time for our children to go back to school and the month when the football season really starts to get going. It is also the month during which many traumatic events have occurred during my career – sterling’s exit from the Exchange Rate Mechanism, the tragedy of 9/11 and the collapse of Lehman Brothers and the onset of the Global Financial Crisis (GFC) in 2008. We are coming up to the sixth anniversary of that and in many ways the global economy is still recovering from the crisis and the legacies it bequeathed. To us the key legacies are the levels of debt that public sectors took on during the near collapse of the financial system and the subsequent recession that followed, the regulatory regime that has evolved in an “horses bolted” attempt to stop the GFC happening again, the enduring lack of confidence amongst investors, company managers and consumers that has held back sustainable increases in private sector demand, and the policy environment. That last point is important. Monetary policy has been surfing the zero-interest rate bound for some time now and this has delivered record low interest rates in many markets. Fiscal policy has been hamstrung by the need to reduce government deficits and put debt to GDP ratios back on a sustainable track. We have some recovery, but policy is still characterised by super-easy money and tight fiscal. No wonder bond yields are low.

 De-coupling –Not all parts of the world are at the same stage of recovery in this post crisis era. When we look at levels of GDP relative to the peak of the last business cycle (I take Q4 2007 as the pre-crisis peak) there is a huge disparity amongst developed economies. Some countries had a relatively rapid recovery due to their more solid banking systems (Australia and Canada) and Germany passed its pre-crisis peak level of GDP as early as the end of 2010 with the US doing the same a year later. The UK has only just recovered its 2007 peak but recent upward revisions to GDP data show the British recession was not quite as bad as first thought. Indeed, other data on the UK economy point to a more robust economy than the GDP data itself (PMI surveys, housing market, job growth). The peripheral European economies, by contrast, are still operating between 5% and 10% below the 2007 peak. This has implications for policy settings because even Germany has slowed recently. The expectation of diverging monetary policies between the US and the UK on the one hand and Europe on the other has been a source of market commentary and speculative activity in bond and currency markets for some time. However, it is now becoming more concrete, particularly in the wake of the ECB’s recent announcement of a further reduction of 10 basis points (bps) in its key interest rates and the launch of an asset backed securities (ABS) purchase programme designed to upsize the central bank’s balance sheet to the level it reached at the end of 2012.  By contrast the Federal Reserve (Fed) and the Bank of England (BoE) are edging towards embracing  the need to step away from emergency interest rate levels. We have already had votes in favour of higher rates by two members of the Bank of England’s monetary policy committee and it can’t be long before someone on the Federal Open Market Committee (FOMC) breaks ranks with Janet Yellen’s desire to wait as long as possible before raising rates.

 Weaker euro at last  –The divergence in monetary policy expectations should be viewed as meaningful and long lasting. Longer dated bond yields have already reflected this with 10-year US Treasury yields now almost 150bps higher than the equivalent German yield and the differential at the 2-year maturity having risen sharply in recent weeks to 60 basis points. With bond market participants suggesting that the UK is the most likely to raise rates first, the spread on 2-year gilts versus German 2-year bonds has risen to 93 basis points. I think it is important to think that once the Fed and the BoE start to raise rates, the intermediate targets for policy rates are going to be something like 200bps above where we are today during a period in which the ECB will keep policy rates close to zero and may even have to do more balance sheet expansion in response to weak growth and low inflation. A spread of 2% between US/UK short term bond yields and euro short term bond yields was last seen almost a decade ago. This is likely to be the biggest relative move in bond markets as longer dated US  and UK bonds are likely to be well supported by European and Japanese investors who are faced with low domestic yields, but it may also mean that the euro faces significant losses against the dollar and sterling during this dislocation of monetary hegemony. Indeed, the market reaction to the ECB in bond-land was relatively muted but the euro has traded below $1.30 for the first time since the first half of 2013.

 Life support –It is true that the Fed and the BoE have subsidised and supported their respective banking systems during the post crisis era. In the UK the government remains a key shareholder in two of the largest banking groups. It takes a long time to run down portfolios of bad assets and a lot of assets became bad during the crisis. The quality of the assets of ongoing business is much better and banks are lending again, so are confident in the quality of the new assets they take on to the balance sheet. In Europe, if one was to take a critical view, ECB life support remains critical. Through the various balance sheet schemes the ECB has provided the European banking system with funding that has been cheaper than market funding, if indeed market funding had been available. This has allowed banks to remain solvent but also to benefit from and provide the fuel for the massive decline in sovereign borrowing costs in peripheral Europe. We could go on to say that the ABS purchase scheme could be seen as a way for banks to accelerate the reduction in exposure to poor quality assets on their balance sheets. Pass the risk on to the central bank! As my colleagues in the AXA IM Research and Investment Strategy team have recently pointed out, Italian banks are still charging very high lending rates to small businesses. This suggests that balance sheets remain stressed and that there is a structural need for subsidised funding. More should become clear when we begin to see the results of the asset quality review (AQR) and the take up of the targeted longer term refinancing operations (TLTRO) but there is something at the back of my mind saying that instead of celebrating the ECB’s actions, we should at least still take some account of the underlying risks in the European economy. Growth has slowed, or at least remains weak, and that is not good for a recovery in the credit quality of assets in the most exposed parts of the economy. On the positive side it is clear that the ECB is pursuing a mixture of QE, through the purchase of assets and the expansion of its balance sheets which could have portfolio rebalancing effects, and credit easing as it provides the opportunity for banks to make new loans and then securitise them for onward sale to the ECB. We won’t see the impact of this in credit numbers for some time though.

 European assets supported by super easy policy –I suspect that the ECB will be the key driver of the fixed income markets in Europe for the foreseeable future, both in terms of how the implementation of the actions announced in June and in September will impact on financial asset prices and the real economy. If the real economy numbers remain disappointing, markets will continue to look to Mr Draghi to do more. He admitted that there was no unanimous view on the purchase of government bonds (QE US and UK style) but if things don’t improve there will remain expectation of this being a realistic option. If things start to improve, the ECB will feel gratified but it will not be in a position to reverse any of its policy decisions for a long time. After all look how long it has taken the Fed to even contemplate an exit and this should be supportive for credit spreads and equities. The cash injected into the market as a result of the sale of ABS by banks and other institutions will need to be invested somewhere, and this may help broaden the easing of financial conditions.

 Growth in US/UK more than 2% more than in euro area, rates should be too –My expectation is that the next few weeks will see markets distinguish more clearly between euro and US/UK rate prospects and for the recent trend of lower Bund yields dragging down US Treasury and gilt yields to be less strong. Much depends on the overall risk climate but if we take our lead from the rally in equities, it is risk on. The trouble for bonds is that there is not much more upside so I suspect total returns will be lower in the final semester of the year than they have been so far in 2014. Credit spreads are likely to move higher more quickly in times of risk aversion than they narrow when things are stable. So even though we are not necessarily bearish on credit conditions, we do see more volatility and with this there will be opportunities to add to fixed income exposure at higher yields and wider credit spreads. One of our three scenarios for this year was that rates would rally because of some disappointments on growth or corporate performance or geo-political risk aversion. In the end it has been disappointing European growth and geo-politicals that explains the rally in rates.  Even if credit spreads haven’t widened that much, credit has underperformed, especially in recent weeks and especially in high yield. Higher rates could not only push overall yields higher but also have some negative impact on spreads. Caution should prevail in an asset class that remains rich even though the technical bid for fixed income remains as strong as ever.

 Vamos Manchester –I mentioned football at the top and it has been an awful start to the season for Manchester United. Losing to MK Dons was probably the low point (fingers crossed) and it appeared to put the nail in the coffin for some United careers. Soon after the cheque book was well and truly opened and something approaching £200mn has been spent on rebuilding the team. I can’t wait to see our new Spanish speaking stars – Rojo, Herrera, Di Maria, Mata and Falcao – line up with Rooney and RvP. Who needs a defence? We’ll score more goals than you. Let’s hope it works!

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