Market reaction to Ben Bernanke’s testimony before the Joint Economic Committee last Wednesday highlighted the critical importance of expectations regarding central policy to asset prices. More importantly, it illustrated the vulnerability of bond markets to significant capital loss.
Discussion of the multi year bull market in almost all fixed income assets and whether this has resulted in a bubble is nothing new. Talk of a great rotation at the beginning of the year was the latest manifestation of this. However such talk has not led to meaningful price moves (see figure 1 below).
Part of the explanation for this seems to lie in a faith in “gradualism” among market participants; namely the belief that changes in monetary policy will be well telegraphed and incremental in nature.
However, history would suggest that this is an incorrect assumption.
Many have singled out the increase in the Fed Funds rate in 1994 as been the clearest illustration of the risks faced by bond markets today, but the recent history of target rates show that that changes rarely follow a smooth path (see figure 2 below). In many cases the lagged effects of previous policy stimulus leave policy markers playing “catch up” in trying to slow economic activity.
At present we are seeing factual improvement in the US economy that seems inconsistent with very low Treasury yields. Jobless claims and housing data have been particularly encouraging.
Moreover the improving health of the US economy has come in the face of meaningful headwinds:
- There has been ongoing fiscal tightening (fiscal cliff, sequestration)
- The industrial sector has been weak globally, with China a particular concern
- Europe continues to struggle in the face of austerity policies
Of course, it is not necessary for policy makers to act for government bonds to sell-off. A change in investor perceptions is enough; whether this is a belief that a change in policy is coming, or simply frustration at missing out on more attractive returns elsewhere.
What are the possible impacts of a rise in real rates across asset classes?
This is not to say that policy change is imminent, it is entirely possible that growth is steady, inflation remains low and the Fed can continue to be accommodative. However, as recent moves have shown, even the implication that there could be a change in policy has prompted confusion in financial markets.
Such moves can have important implications for the correlation between assets and the available diversification in investors’ portfolio. At the end of May both equities and bonds fell together and the question is whether this can be seen as sustainable. If changing perceptions of policy are based on a belief that central banks are tightening too much, then this could harm risk assets such as equities and corporate bonds.
Alternatively, if policy changes are anticipated because of a strong recovery, one could well expect an appreciation in risk assets.
How do you structure a portfolio in the environment?
As investors we need to constantly ask ourselves which scenarios will be supportive for our portfolios, and whether we have enough protection to limit losses in those that are harmful. In M&G’s multi asset team, we strongly believe that valuation signals are an important guide in this respect.
So how do we seek to construct a portfolio to negotiate an environment of rising real rates? First, our view is that such a scenario could see many assets and strategies that have been unpopular during the bond bull market of recent years doing well. This could include selected equity markets where attractive valuations offer a margin of safety that is not present in traditional “safe havens,” many of which have been driven to deeply expensive levels.
It is also useful to seek fixed income assets where valuations appear to offer some protection in the face of a rising rate environment , this could include high yield corporate bond where it is possible to access the spread (particularly at longer maturities) or selected emerging market government.
In terms of protection for a portfolio, our view is that short exposure to US Treasuries of short to intermediate maturity could also offer compelling risk and return properties. With yields at close to all-time lows, and assuming that yields lower than zero are unsustainable, these positions (unlike short exposures to equity markets) offer asymmetric return distributions; that is, yields have far more scope to rise significantly than they do to fall.
Managing the relative allocations to these themes, observing changes in market perception and reacting to asset price volatility will, as always be key to negotiating the period ahead. It seems likely that the volatility in other assets that could be prompted by large moves in real interest rates will create investment opportunities.