In recent days and weeks we seen have sharp movements across large parts of bond and currency markets. Until the past couple of days, bond yields had been moving upwards with alarming speed over pretty much all of Europe (with the exception of Switzerland and Sweden) and in the US and the UK, prompting concerns of a coming storm in bond markets.
Meanwhile, it has been a lively few days for currency markets. On Tuesday morning the Wall Street Journal’s front page led with “Investors Pull Back on Bets Against the Euro”, citing the euro having touched a 10-week high last Friday. It seemed many investors were closing the short-euro positions they had put on earlier this year. However, by close yesterday, the euro had slid more than 3% against the dollar since Friday (see figure 1).
Speculation about moderate ‘front-loading’ of European QE was one possible cause, but another key driver of all this turbulence seems to be investors’ yo-yoing expectations of when the US Federal Reserve will raise interest rates. This has been a major focus for markets for some time but the predictions game has become especially frenzied in recent days as market participants try to untangle a coherent message about US growth prospects from mixed signals on the data.
In our view, such volatility is hardly surprising given the market environment in which we find ourselves today. We currently observe a deeply unstable equilibrium in terms of the impact of negative real interest rates in several places on asset pricing across much of the global investment landscape (see figure 2). There is some confusion among commentators about the extent to which QE has distorted prices but we believe the real issue is that these cash rates dictate how much investors want to be compensated for holding all other assets.
It seems to us that investors have been surprised by negative nominal rates – something which not too long ago was outside the scope of most people’s beliefs about where these things could go. How do we price anything in this environment? The rally in bonds up until the end of the first quarter of 2015 has been about this endogenous uncertainty and resulting ‘value vacuum’ in which several bond yields turned negative.
The specific reasons behind the more recent bond market pull-back are difficult to pinpoint, maybe it is the slight increase in the oil price, or maybe it has to do with US unemployment numbers continuing to paint a more positive picture, or maybe investors have simply turned to look more closely at valuations and seen that these assets had become too expensive. We actually think the backdrop created by all of these factors mean yields in several areas look quite plausible now. Not attractive, but plausible in that it is possible to defend such low yields in an environment of negative cash rates. Plausible, for example, in Europe, in the sense that a reasonably rational set of assumptions about factors such as inflation and interest rates mean German 10 year yields at 0.6% are not attractive, but not particularly expensive either. Peripheral yields, notably in Spain, look better value than Germany however.
In the US, treasury pricing no longer looks quite as distorted as a few weeks ago, although we still see some meaningful risk should interest rates increase more quickly and/or to a greater degree than currently expected by the market. As a consequence, US treasuries remain unappealing to us and our more likely disposition would be to short or underweight these assets to provide some helpful diversification in a repeat of the type of scenario we saw around 2013’s ‘taper tantrum’.
In our view, the US economy remains in a reasonably solid place, with employment data still quite strong and the Fed describing the reasons behind slightly lower GDP data as temporary. Certainly, US recovery continues to outstrip the Eurozone’s, which provides the most useful context for thinking about recent currency movements. If we take a step back from the most recent data and look at these two economies in relation to each other on a three-year view, which one seems more likely to raise rates first? Therefore, it is the US dollar that still looks more attractive versus the euro, and several other currencies.
Certainly we are beginning to confront a situation where US interest rates are looking likely to start ‘normalising’ to some extent, even if we can’t know the exact timing, which has the potential to pressurise lots of other assets. However, many assets are today priced as if extremely low cash rates are near-permanent. No wonder investors can’t decide what they think will happen next. For us, the point is that we cannot know. The recent journey in bond and currency markets has been rapid and investors will have been shaken. We should get used to such acute volatility, it is likely to be a recurrent feature of markets in the period ahead whether rates rise or stay low for longer, so there is a binary element to that in a sense, which is extremely difficult to confidently call on either side. In conclusion, there may be skewness in the return distribution for bonds as yields are more likely to rise than fall from current levels.