Global bond and currencies
Newton Fixed Income
18 June 2009
Newton global bonds and currencies strategy: we expect the US yield curve to flatten and we are staying overweight the long-dated part of the curve and hedging that position with exposure to Treasury Inflation-Protected Securities
There are tentative signs of economic recovery at the moment but, while all commentators would agree that the recovery is taking place from a very low base, many disagree about how long it will last. As when looking at the illusion above, we could just go 'round and round' at these relatively low levels of activity for some time yet.
What is needed to escape the malaise is a credible plan to reduce the levels of public debt. Spending increases and fiscal stimuli, while required during times of economic collapse, are counterproductive once the worst is over. This is especially the case in the US, where the housing market is very sensitive to long-term borrowing rates, which are very sensitive in turn to the scale of government bond supply that is required to keep the fiscal stimuli flowing. The more the government borrows to keep the economy alive, the higher the cost of borrowing generally will be, the more vulnerable the housing market will be, and the more the government will be required to stimulate that market…and around we go again in a vicious circle.
The US administration under Bill Clinton faced the aftermath of an economic slowdown and responded to that slowdown (despite its Democratic allegiance) by putting in place plans to reduce the ballooning budget deficit. Long-term borrowing rates fell in response and the Federal Reserve helped by keeping monetary-policy rates low. Once the market started to believe the authorities were determined and able to lower the deficit in the future, the bond market rallied as predictions of supply were scaled back. The yield curve dropped dramatically and continued to flatten when the Federal Reserve started to raise interest rates. President Obama is likely to follow the same course, so we should expect talk of cost savings and lower borrowing requirements in the future.
The green shoots of economic recovery may wither over the coming months as some of the effects of policy stimulus fade away and as the effects of previously falling energy costs begin to wane. Mortgage rates have also risen by 100 basis points (1%) in the last month and the housing markets remain racked by high delinquencies and falling prices. Against this kind of backdrop, the recent talk of an economic recovery and a Federal Reserve move to tighten monetary policy is hard to fathom. In previous economic downturns, the US central bank has waited until it is convinced we are past the trough in activity before it has looked to raise interest rates. With unemployment rates being a lagging indicator, this tends to lead to fears that US monetary policymakers are 'behind the curve' (but they tend to catch up fast).
What we are seeing in 'risk' markets is a response to the massive amount of monetary stimulus that has been thrown at tackling prevailing financial difficulties. As much of the stimulus has not been targeted at particular areas, it is leaking out into all sorts of 'unwanted' places. If it finds its way into the commodities markets, it will lead to higher headline inflation, but given the enormous size of output gaps and the extent of surplus capacity in the global economy, core inflation should remain subdued. The authorities will need to keep the markets focussed on this core inflation rate to retain their credibility.
Once the recovery takes hold, the authorities will need an 'exit strategy'. A synchronised tightening of both fiscal and monetary policy might be difficult to achieve given the fragility of the financial system and the economy. Monetary tightening by the Federal Reserve would jeopardise the housing market, but fiscal tightening would have the benefit of keeping long-term borrowing costs low. The fallout from loose monetary policy and tighter fiscal policy is likely to entail a declining dollar and greater stimulus in the world economy. The Federal Reserve acts as the world's central bank, owing to the dollar's status as the world's 'reserve currency'. Low dollar interest rates are transmitted throughout the world and help to create widespread 'bubbles' (especially in emerging markets that have their interest rates linked to those of the US). China is using some of this dollar liquidity to stockpile commodities.
One example of how a bubble can form as a consequence of this cheap funding is in relation to the oil price. It is currently very cheap to borrow dollars to buy oil. One can also rent a tanker cheaply (because global trade is very depressed and the movement of goods to end markets has slowed sharply) and use cheap dollars to store it. The oil price has been rising since the beginning of the year, being fuelled by cheap dollars, despite a massive increase in the amount of oil currently stored offshore. As yet, 'real' end demand for this oil is unproven. Nevertheless, the short-term feedback to the US economy occurs in the form of rising energy costs and higher headline inflation.
US inflation-linked securities can benefit from the increase in headline consumer price inflation, but at the same time the conventional Treasury market can benefit from the decline in the core rate of inflation. Both markets should benefit if the Federal Reserve switches its quantitative easing (QE) programme towards buying more US government bonds (and away from mortgage-backed paper).
FEDERAL FUNDS RATE VERSUS 30-YEAR
US TREASURY YIELD - ABSOLUTE YIELDS
(TOP CHART) AND SPREAD
The flattening of the yield curve has begun. The chart shows the history of the Federal Funds rate compared to the yield on the 30-year Treasury bond. The difference between the two is close to its historical highs, suggesting that economic recovery has been priced in.
What happens next? Once the greatest depth of the recession has been passed, long bond yields are likely to outperform short bonds on a relative basis and the yield curve would flatten therefore. This could happen in two ways:
- If there is a strong economic recovery, outperformance of long bonds would be likely to occur during a bear market for all Treasuries, with yields rising by more at the short end (pricing in rate increases)
- If the recovery is more hesitant and the Federal Reserve increases its QE activity, then outperformance would be likely to come from falling yields at the long end. With the evident risks to economic activity in the near term, we think the second path of falling long yields is the more likely for now. We have changed our US bond allocation (given that we anticipate the yield curve will flatten rather than steepen) by switching from 4-7 year bonds into 10-30 year bonds. At the same time, we have increased marginally our inflation-linked securities and taken profits on our US agency paper.
Unless otherwise stated, all data is sourced from Bloomberg or Thomson Datastream.
This is a financial promotion and is not intended as investment advice. The opinions expressed in this article are those of Newton Investment Management Limited. Past performance is not a guide to future performance. The value of investments, and income from them, is not guaranteed and can fall as well as rise due to stock market and currency movements. When you sell your investment, you may get back less than you originally invested. The opinions expressed in this article are those of Newton Investment Management and should not be construed as investment advice.
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