Carry Me Home

  • Global easing
  • Cyclical adjustment?
  • Rates bottomed?
  • Global bond opportunities
  • Upside for yields limited
  • Modest risk-on bias
  • This sporting life

The market is trading like it believes the mid-cycle correction story rather than the impending recession narrative. Equity and credit markets are doing “ok” and rates have bottomed for now. Investors are weary of the US-China trade story and Brexit and are questioning just how weak the global cycle really is. This is not to say it’s off to the races again with risky assets, just that things might not be quite as bad as suggested by the deeply negative trends in rates we saw in August. Some of the recent data prints have stabilised and employment conditions in major economies are good. Central banks have responded to downside risks and market direction for the next few months will come from the data, the materialisation or otherwise of the global risks, and any progress towards a different macroeconomic policy balance. In bonds that suggests getting exposure to yield where appropriate and looking for return from carry strategies (even though carry is not what it used to be).   

Global easing

While there has been a lot of talk recently about the lack of effectiveness of monetary policy – especially in the context of the Euro Area where inflation continues to run significantly below the European Central Bank’s (ECB’s) target of roughly 2% - markets are still hooked on central bank decisions and the interest rate outlook is a key input into both economic and financial return forecasts. Thus, if you want a reason to be optimistic that the global economy can avoid a recession in 2020 one just has to consider just how much monetary easing there has been this year. The real global policy rate has fallen since the first half of 2019 with a 50 basis points (bps) easing by the Federal Reserve (Fed) since June, a comprehensive package of easing in Europe and a whole host of emerging market central banks cutting rates. Significant cuts in policy rates have occurred in Brazil (-100bps since June), Indonesia (-75bps since June), Mexico (-50bps), Russia (-50bps) and Turkey (-425bps). In addition, China has taken a number of steps to ease monetary policy including reducing the reserve requirement by 150bps this year. The ability of emerging market central banks to cut rates reflects a lack of inflation concern but also, overall, reduced financial instability. Except for the Argentine peso, most emerging currencies have remained quite stable against the dollar over the last quarter.

Cyclical adjustment?

Lower policy rates have led to lower bond yields and lower bond yields mean lower discount rates in equity valuation models. This means that financial asset prices can stay elevated as long as the world economy chugs along. The developed market data released in September so far has suggested some stabilisation in global manufacturing with supply chains adjusted to the more difficult trade environment. The US manufacturing sector stabilised in August according to the ISM index (51.3 vs 51.2) while the services sector measure was also unchanged at the 50.9 level. In Europe the purchasing manager indices were also stable, with the manufacturing index at a lower level than in the US but the services measure above that in the States. It’s likely too early to call that the cyclical adjustment to growth is over but with the additional monetary support in place the risks between further economic weakness and a modest rebound have probably shifted to a slightly less negative balance. Of course, there remain potential sources of additional weakness as there is, currently, no trade deal between the US and China and no clarity on Brexit, but we can’t rule out a deal on both issues in the coming weeks. Keep in mind that employment levels and wage growth is very healthy in a number of places too and this will support consumer spending.

Rates bottomed?

The bond market has certainly called time on the need to pursue even lower rates. Core government bond yields bounced in September and have stabilised since the actions of the central bank over the last week or so. In the wake of AXA IM’s quarterly fixed income forecasting session we concluded that the most likely outcome for core yields is for range trading ahead of the end of the year, especially if there is no big change in the economic data flow. A sharp move higher or lower appears to have a more or less balanced probability but for choice I would think that the ongoing demand for higher quality long duration assets will tend to push yields back towards the lows we saw in August, even if they are not necessarily breached. On the credit side, risk measures have improved since the summer with the crossover credit default swap (CDS) index in the European market having fallen from 290bps in early August to below 250bps today. Credit sectors have performed better than government bonds in September – some of them by quite a margin including US investment grade, US high yield, peripheral European sovereigns and emerging market sovereigns and corporates. European inflation linked bonds have also outperformed. One could take all of these moves as a sign that investors have shifted towards a reflation trade. Equity markets would substantiate that too with solid gains across developed and emerging equity markets despite the significant rotation within the S&P500 between growth and value.  

Global bond opportunities

Another interest rate related development which should be of interest to global fixed income allocators is the evolution of the price of hedging US dollar currency risk. Using foreign exchange forwards to lock in currency stability is a common technique amongst global bond managers and the forward rate is determined by interest rate differentials between the two currencies in a foreign exchange pair. Because US dollar interest rates have been higher than those in the Euro Area, sterling, Switzerland, Japan and elsewhere, hedging dollar exposure has been quite expensive. The forward dollar rate against other currencies has a built in lower rate depending on the rate differential and this has meant that hedging a dollar bond portfolio into, say euros, has resulted in a hedged yield (ex ante) and hedged return (ex-poste) that has been lower in the other currency relative to the dollar yield and return. At its worst, the annualised “cost” of the hedge using 3-month forwards between the US and Euro was over 340 bps. With two Fed rate cuts in the bag, this has fallen to around 260bps. So now a 10-year US Treasury with a yield of 1.78% has a hedged yield in Euro of -0.82% compared to a 10-year Bund yield of -0.51bps. The US is still less attractive to Euro investors, but the gap is coming down. On the credit side, hedging similar credit rated assets back to Euro still gives a preference to Euro assets in terms of yield. However, dollar assets are more attractive from a potential capital gain given that rates do have further, potentially, to decline. The US investment grade 1-10 year BBB bond sector currently has a yield to worst of 2.97% while the equivalent segment in the Euro corporate bond market yields 0.63%. The averages might be misleading given the large number of bonds in the Euro area with a negative yield, so it is likely that, a higher yielding portfolio can be created out of US assets than Euro assets of equivalent risk. If the Fed cuts one or two more times, the hedging cost will fall further.  

Upside for yields limited

It is rather technical but the fact that rates remain below zero in Europe and Japan is a key reason why we don’t see much upside for US Treasury yields. If the US market sold off and yields rose, the hedged yield in Euro and Yen would become more attractive relative to local markets and global investors from those markets would likely increase their allocations to the US. This has played out several times in the last few years and was a key reason why Treasury yields failed to rise significantly above 3% even when the Fed was firmly in a tightening mode. Investors in zero interest rate monetary zone need yield and if the US market offers the potential for higher yield then it will attract capital. Given the negative slope of the US interest rate curve those institutional investors that hedge the entire maturity of their bond holdings through the cross-currency swap market are already able, in some cases, to extract better value from US assets than from those available in Euros. In recent years the FX hedge has actually worked in the favour of USD based global bond investors because hedging Euro or yen or sterling assets back to USD has provided a yield pick up over the US market. If Bund yields are at -0.5% then hedged into dollars the yield is 2.1%...that is well above what is available in the US Treasury market. This will all change as the gap between US and other policy rates converges again but only if the macroeconomic conditions allow further easing by the Fed (tightening by the ECB is not on the agenda any time soon).

Modest risk-on bias

Our regular review of the outlook for fixed income concluded that rates are likely to be more stable in the short-term – obviously depending on what happens with global risk appetites in response to potential developments on trade or Brexit. We see credit spreads also stable to a little lower, so total returns from bond portfolios might be less driven by price gains and a bit more by carry in the next few months. This should not do too much damage to the returns already made in bond portfolios in 2019, but the hard work has been done and it might be the case that a more cautious approach is taken by money managers in the fixed income markets. As discussed at length recently, the game changer for the bond market will be if and when we get more activity on the fiscal side from governments. Many European governments are running budget surpluses and most OECD countries will have lower deficits in 2020 compared to five years ago. Together with lower borrowing costs this provides a lot of fiscal space. The exception is the US where the deficit is increasing, and the OECD expects it to be above 6.5% of GDP next year. Recent volatility at the short end of the US money market shows how increased borrowing by governments can disrupt rates markets and crowd out liquidity. If governments issue more in Europe it could help mop up the massive amount of excess reserves in the Eurosystem as cash will get eaten up by Treasuries. Fiscal expansion will mean higher rates but in the initial phase, the ECB’s policy set-up is to accommodate increased borrowing. We wait for further developments on these issues.

This sporting life

The Rugby World Cup is just getting underway as I complete this note. I am a lover and viewer of most sports but unlike a lot of my friends and colleagues I can’t get as excited about the oval ball game as I can about football and cricket. Having said that, I expect I will get more interested as the tournament progresses and especially if England (and Scotland for my wife’s sake) do well (ahem!). I’m sure Japan will be a great venue for all the fans from the participating nations – the food alone would be worth going for. On the football front it’s quite amazing that United are in the top four having only won two of the first five games of the premier league season. We are ahead of both Chelsea and Arsenal and only two points behind (favourites for everything) Manchester City. Ole is trying to rebuild the United squad but injuries have left it quite depleted. He turned to youth in the Europa League 1-0 victory over Astana, but it is a different thing to ask inexperienced teenagers to lead the line in the premier league. In time it will pay off, but this season might be a tough learning experience for the likes of Gomes, Greenwood and Chong. But it’s been done before, and you can win things (eventually) with kids.