Core bond yields are close to this year’s high, says AXA’s Iggo

The rise in yields reflects more optimism on the global economy and more uncertainty about US monetary policy, according to Chris Iggo, CIO Fixed Income, AXA IM.

100bp is what we got

A better global economic outlook and uncertainties over the next phase of US monetary policy have resulted in core bond yields being some 100 basis points higher today than they were at the beginning of 2013. Given that yields were very low at the beginning of the year this move in the yield curve has led to a negative total return for the US Treasury bond index and to poor returns for other assets that have a significant sensitivity to US yields. The US investment grade credit market has delivered a small negative return but so have the UK gilts and German bund indices. Credit spreads have generally narrowed in the investment grade and high yield developed markets with European indices providing the best positive returns on average – weak growth is good for fixed income. Within investment grade it has been subordinated financials that have continued to deliver the highest total returns driven by the on-going adjustment to the capital structure of Europe’s banks. Generally, with higher core yields and credit spreads narrowing, it has been a year of compression in fixed income markets. If not much changes before year end, core government bonds will be a bit higher while overall yields on spread products will generally be unchanged (investment grade) or lower (sovereign peripherals and high yield). The outlier is emerging market debt where spreads and yields are both higher today than at the beginning of the year with some emerging market currencies being significantly lower against the dollar. Recovery is a little more advanced, systemic risks have diminished and yet central banks are either genuinely contemplating more easing (European Central Bank (ECB)), or are trying to convince investors that any tightening of policy remains a long way ahead. Those themes will persist into 2014.

Looking forward, as always it’s all about the macro 

So here is an early attempt to identify some of the main themes for 2014. It may be a little early but this is not an attempt by me to get in there first. Rather it looks like my schedule for the rest of the year may provide only limited opportunities to publish Iggo’s Insight, so I will use today to start to think about some of the main themes. My team will hold its end of year forecasting meetings in early December and the following will most likely be the topics we discuss internally and with external economists and strategists in order to manage the risks and seek alpha generation in our portfolios in the early part of next year. Our philosophy, as always, is that the key drivers of the performance of fixed income assets are either changes in the level of interest rates (or interest rate expectations expressed through the yield curve) and changes in the level of credit risk premiums (either at the sovereign or corporate level). Trying to understand what drives changes in interest rate expectations and the level of credit premium investors require to take on risk, above the core yield curve, is what drives our investment process and what makes us, as bond investors, get up every morning. At the market level we firmly believe that top-down factors are extremely important in determining expectations about rates and credit spreads and it is these macro factors that we focus on in the initial phase of our investment process. One can be very good at selecting the bond of one issuer over another but if you misjudge moves in interest rates or underestimate the potential for an increase in systemic credit risk all the positive contribution to a portfolio’s value form good credit selection can very easily be overwhelmed. The asset allocation amongst the key top-down risks – rates, inflation, sovereign credit, corporate credit, country risk, sector risk, default risk and equity like risk – is what determines a long term successful strategy in fixed income investment.

And central banks

UK most likely to tighten, not remain at 0.5% for ever – Let’s start with rates. The most likely place to look for an early increase in interest rates is the UK. As I suggested last week, the Bank of England is now pursuing the notion that it can allow the economy to operate at unemployment levels below 7% without triggering an increase in rates and this was the message that came out of the Inflation Report recently. The combination of potential further declines in the unemployment rate to below 7%, the chances that inflation in the UK re-accelerates once all the utility and transport price increases feed into the index and the potential for policy makers to become concerned about a housing boom suggest to me that there is about a 60% change of the Bank of England raising rates next year. That is my view and others will put different probabilities on that outcome but a year is a long time and I am still saying that there is a 40% change of no hike. After the UK we have to think about the United States, but that is more challenging. I would only put a 10% probability of the Federal Reserve (Fed) actually raising the Fed Funds rate but there is a 100% chance that tapering will take place and that by the end of the year the Fed’s balance sheet will have stopped expanding. Yet the uncertainties around the US stem from the difficulty that this Fed is having in communicating its view that tapering is different to tightening. An end to QE combined with even more emphasis on forward guidance could do strange things to the shape of the Treasury yield curve. Short rates would remain anchored if the market believes forward guidance while the end to QE could lead to higher yields on longer maturities. As some research pointed out this week, this is the reverse of what Operation Twist set out to do (flatten the yield curve). The spread between 2s and 10s could easily increase back to 300 basis points under this uncertainty.

ECB on hold 

I can’t see how the market can price in any tightening of ECB policy. So there is a 0% chance of a rate hike in 2014, a 70% change of another token rate cut and I would suggest something like a 30%-40% chance of some kind of QE. Perhaps another LTRO is still more likely than QE but something big could be seen from the ECB. The macro backdrop is weak, with the flash PMI for November at just 51.5 for manufacturing and 50.9 for services, a little bit weaker on the composite measure than in October. In addition, inflation is low and falling and the exchange rate is strong driven by a euro area current account surplus and strong capital inflows. More on Europe in a moment but let’s round off the main central banks by attaching a 0% probability to the Bank of Japan either ending its own QE or raising interest rates. Japanese inflation could hit 2% in 2014 but what Japan needs is confidence that both growth and inflation can be sustained at a higher level and that the debt to GDP ratio can be sustained. Putting all that together makes me strategically bearish on gilts and Treasuries, and relatively more positive on bunds and JGBs.

Lots of things to focus on in Europe 

On the sovereign credit risk side, the themes in Europe will be around the banking review, the ability of programme countries to go it alone and whether both bank and sovereign balance sheets are strong enough to withstand any changes in the regulatory environment that make it more difficult for banks to hold sovereign bonds relative to other assets. At the outset I am a little concerned about Italy where growth is weak, structural reforms have been delayed by political uncertainty and, so far, there has not been the comprehensive review of the banking sector the likes of which have been undertaken elsewhere. The worst case outcome from the banking review is that large recapitalisation needs are identified and markets are unable or unwilling to provide the new equity capital such that there has to be consolidation and bail-ins that will fall on bond holders before tax payers. I am not qualified to guess where these problems might emerge and think that there is a considerable opportunity for banks to clean up their balance sheets before the Asset Quality Review (AQR) returns its findings, but it will be a key theme and market expectations will need to be monitored closely. On the sovereign side it will be interesting to see what support the market gives to Ireland given its recently stated intention to leave its EU/IMF programme without agreeing on a contingency credit line. To me this is a good sign as surely the European authorities must be confident enough that Ireland is strong enough to fund itself (anyway I bet the credit line would be there if it was needed in extremis). Where Ireland goes, Portugal could eventually follow. After the significant narrowing of peripheral spreads this year I guess we could be in for a pause as some of the uncertainties about further progress on fiscal consolidation and the outcome of the banking review will play on investors’ minds. But for now it seems reasonable to remain overweight on Spain, a little less so on Italy and to express more of a negative view on some of the core markets that have lagged in terms of structural reform and fiscal consolidation (France and the Netherlands, for example).

Some people want inflation 

If central banks continue to argue that rates need to stay lower for longer, a key motivation for that view will be their own expectations on inflation and the performance of inflation itself in the short run. As I said last week, avoiding further disinflation has to be a central part of the on-going recovery from the debt crisis of recent years in order to sustain declines in debt/GDP ratios. Some Federal Open Market Committee (FOMC) members have recently talked about setting an explicit floor for US inflation so that QE or rates policy would be guided by maintaining inflation above that level. The Bank of Japan (BoJ) is committed to raising Japanese inflation and this has recently found some favour amongst foreign exchange market participants who have been selling the yen. No-one in European central banking circles would publicly admit to targeting higher inflation but even there we see a desire to get inflation back to close to 2%. (As an aside, for the UK inflation outlook, don’t worry about it being too low Mr Carney). The evolution of inflation and the role that will play in policy could ultimately be the key driver of monetary policy and the distribution of real returns on fixed income assets. Inflation linked bonds have had a poor year because of the rise in real yields in 2013 and the modest narrowing of break-even spreads, but 2014 could be another story. Real yields may still be biased to moving higher but so may inflation expectations and realised inflation. I would put even money on US inflation being higher in October 2014 than the 1.0% year on year inflation rate recorded for this October.

The great rotation or modest deployment of cash? 

The great rotation out of bonds into equities never really took place, did it? Happily bond returns this year have been modestly positive in some areas while equities have performed very well without having benefitted from the massive asset allocations that the pathological bond haters forecast a year ago. Will we get the same predictions again in 2014? We might get the predictions again but I doubt we will have the “great rotation”. Equities are at all-time highs and the good old relative yield spread between the two has improved in favour of fixed income since this time last year (the 10-year US Treasury yield is 80bp higher than the S&P500 dividend yield, although that is not the case in the UK where the equity yield is still well above gilts, but less than it was). The S&P has outperformed the Treasury index by more than 25% and I would suggest that there is probably less than a 30% change that this will be repeated in 2014. There might well be academic arguments suggesting that equities have not been the beneficiary of QE but from a market point of view I would disagree. After all, isn’t the portfolio rebalancing impact meant to be one of the indirect consequences of suppressing the risk-free rate? Change the flow of liquidity and all risk assets will be impacted.

He’s better than Messi

I am sure there are many more themes that we will be focussed on next year and I will address them in time. On the sporting front the World Cup is clearly the stand-out event. Congratulations to France for overcoming the 2-0 deficit against Ukraine – the office banter here would not be the same without England and France in the same competition. I am very biased of course, but I was also pleased that the Portugal versus Sweden tie ended with Ronaldo getting four goals over the two games compared to Ibrahimavic’s double. At the age of 32, Zlatan has probably missed his last opportunity to play in a World Cup tournament. He has apparently said that a World Cup without him is not worth watching and, given his considerable opinion of himself, I think we should look forward to the next phase of his career. Surely he must be able to turn his talents to something that will keep him in the limelight – a movie actor, politician, Secretary General of the UN, King of Sweden? Whatever he does, I am sure he will be a fabulous success, but I am glad it will be Christiano in Brazil and by then he will surely be the owner of a Balon d’Or title. Viva Ronaldo!

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