AXA’s Iggo sees risk-on environment pushing spreads lower

Central bank action to contain concerns over the effects of tapering of quantitative easing programmes has resulted in a resurgence of a ‘risk-on’ environment, which could see spreads go lower again, says Chris Iggo, CIO of fixed income at AXA Investment Managers.

“Summer lovin'” or “Cruel summer”? 

Much as I am a big fan of the 80s pop band Bananarama (I actually lived around the corner from them in North London for a while, strategically timing my visits to the local Chinese takeaway when I thought they might be popping in for some Chow Mein), the rather more pappy tune from Grease seems to be a more appropriate backdrop to market sentiment at the moment. May and June were difficult for bond investors.

Good news led to bad outcomes as the Federal Reserve (Fed) responded to signs that the recovery was becoming more robust by discussing the prospect of taking very small steps towards a normalisation of monetary policy. There is something about the month of May isn’t there? Is it the Gemini effect that causes rapid changes in sentiment? Certainly the rise in yields and widening of credit spreads, not to mention the close to 8% drawdown in the US equity market, give investors an insight into how market valuations had become so driven by quantitative easing (QE). However, since the end of June things have been a lot calmer. The weather has been fantastic, the sport phenomenal and returns from both bonds and equities have been strong. Indeed, of the major bond market indices I follow on a regular basis, only the US Treasury index displays a negative total return for July. Everything else is up with high yield, emerging markets and sub-ordinated financial debt leading the way. US Treasury yields are 100bp higher than they were in early May which, to me, signals that the market has now priced in tapering. With Bernanke going all out to persuade us that actual monetary tightening is a long way off and that tapering will take place in a very orderly manner, we are very much back in a “risk-on” environment. Summer lovin’ indeed.

Back to school

Looking beyond the summer holidays I suspect that monetary policy issues will remain the dominant macro theme for the bond markets, particularly if the recent improvement in economic data continues through the second half of 2013. How the Fed winds down its current pace of asset purchases will be critical but so will the growing focus on forward guidance. As a reminder, forward guidance is really about central banks making a strong commitment to make future interest rate decisions conditional on either a time frame or some macro-economic objectives.

In a sense it is just a different way of communicating on existing monetary frameworks. The Fed’s objectives, as set out in the Federal Reserve Act, is to promote the goals of maximum employment, price stability and moderate long-term interest rates. The European Central Bank (ECB) and Bank of England (BoE) have price stability goals and the Bank of Japan’s intermediate policy objective is to restore positive inflation in Japan after a long period of deflation. Essentially forward guidance is the idiots guide to monetary policy with central bankers saying – “we have legislative objectives, here is what they look like in practical terms (6.5% or lower unemployment rate, for example), and we promise not to surprise you by raising interest rates until these targets have been reached”. The Fed is more advanced in its messaging than its colleagues in Europe, but the ECB and BoE are getting there.

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