Opportunity knocks in fixed income markets

Q Is it fair to say that bonds once had an unassailable place in portfolios as the core risk-free asset but perhaps that is now changing, and a new way of managing bonds is emerging, which includes moving away from buy and hold to a much more opportunistic approach of trading fixed income securities? 

A Yes, there is a clear evolution in bond management, both in the short and long term. In the short term, this is due to the shape of the curve, mainly an effect of the ECB monetary policy. Usually, the higher the duration risk, the higher the return. But today the shape of the yield curve is flat, close to zero, for 10-year bonds, and interest rates are negative, so you no longer have a premium to buy duration. This means that when managing bonds you have to take into account that you can no longer rely on duration carry.

In the long run, regulatory changes in the eurozone, which affect banks in particular, have had an impact on investment banks’ behaviour. There is less market making and more brokerage, which leads to a less efficient market. This generates a higher short-term volatility, offering investors significant trading opportunities.

Q Will the sheer scale of the European Central Bank purchases necessarily prove positive for bonds?

A The so-called ECB ‘bazooka’ means one quarter of outstanding government bonds will be bought by the ECB. The first impact we have seen is lower volatility in bond yields. With the yield coming from the minus 20 basis points of the deposit rate, it is still around zero for five year bonds and around 0.2 per cent for 10 year bonds. The ECB’s objective is to drive global investors to reallocate their eurobond exposure to other countries, in order to weaken the euro. But for the time being, international investors still favour eurobonds, seen as a ‘risk-free’ asset, especially German Bunds.

Q How do bond managers view the changing personality of the ECB Did you once see it as a sleepy player and now perhaps a much more imaginative, daring central bank and would you see that as a positive or a negative label for the ECB?

A In the past we used to criticise the ECB, questioning the credibility of its monetary policy. I believe it was necessary to ensure the credibility of the eurozone. During the crisis, the ECB changed its approach, with the focus now being on the monetary policy transmission and its effects on markets; it is a pro-active central bank, with a typical Anglo-Saxon approach, like the Bank of England and the Fed. The ECB now provides forecasts both for the inflation rate and economic growth, which is quite important for the eurozone.

Q Is it likely that interest rates and bond yields will be dragged down further into negative territory, with possibly a massive distortion of global asset prices?

A The market trends are clear – yields are going down because of demand for bonds. We still have inflows in bonds in the eurozone. Economic surplus is important, and every month around €25bn of cash flows into the euro currency. 

Also, compared to other regions, the eurozone is still characterised by large savings, which seek safe investments, such as bonds.  

Due to the low level of yield, the yield curve can be split into two parts. Below seven years maturity we think there is no risk, thanks to the ECB monetary policy. But for higher than seven years maturity, it is difficult to maintain a bullish view on euro-denominated bonds.

If you think the ECB’s bazooka is going to work, expectations are for higher growth and a higher inflation rate, and at some point the yield curve will steepen. 

Also, a large part of government bonds have been bought by non-euro investors, who will look to other government bond markets in the world generating higher returns. Asian investors in particular will sell eurobonds in favour of US bonds likely to offer higher returns, as the Fed is finally expected to hike rates and push the government bond yield higher. This is why we predict the bund yield will go back to around 1 per cent on the long maturity by the end of the year.

Q What you’re saying suggests an increase in disconnect between the behaviour of bonds in the US on one side and Europe on the other side, with yields moving higher in the US. Where do you fit the UK into that pattern?  

A Based on positive economic outlook for the UK economy, we anticipate the UK will follow the US market. The QE programme has been effective, and central banks in Anglo-Saxon countries will have to take into account the credit activity, which is improving significantly. 

The financial crisis was due to a credit bubble, and the question now is: ‘Are we going back to another bubble?’ 

We believe the commercial credit activity is too buoyant in the US. And in the UK it is coming back, with London proving better than expected. So, it is important for central banks to change from a very accommodative monetary policy to a neutral monetary policy soon.

Q Are you expecting further catalysts for bond markets, potentially from the US Federal Reserve?

A We expect a normalisation of the monetary policy. The latest figures from the US economy show positive signals due to consumer spending and better than forecast corporate profits. On the other hand, the dollar is stronger than anticipated, the demand for energy is falling, which could positively impact the US economy.  This improved economic picture justifies the start of the normalisation of the monetary policy and higher rates. But for us the question is more about the re-pricing of the whole market, namely the credit market. And the shape of the yield curve is perhaps too flat to price in this positive economic picture for both the US and the UK.

Q Are you worried about a Greek exit from the eurozone? 

A Greek exit, and whether the country should be helped again or not, is mainly a political question, considering Greece has done a lot already but has not managed to finish its reforms. What is sure is that with the election of the radical left-wing government, the domestic economic activity has come to a halt. Corporates have started postponing investment expenditures, and banks have suffered outflows. So the whole economy has collapsed, in wait for new government policies. 

Q Here in London the two main parties are at each other’s throats about economic policy, in view of the upcoming election.  But if we look at the growth forecast, ranging from 2.6 to 2.7 per cent, there doesn’t seem to be a huge amount of difference for bond markets, whichever party wins. How do you feel?

A This is the result of a very expansionary monetary policy, which forces investors to buy safe assets, without taking into account the short-term economic picture. The question is whether it is a sustainable growth pace and whether it will bring an acceleration of the economy and will spread to wages. 

The issue for bond markets is still around wages, as the economic recovery in the G7 countries, except for Germany, is not leading to higher wages. 

In Germany wages were stable for more than a decade, so today’s higher wages are a way to offset the past. But the market is still positive on bonds because there is no disconnect between the economy and wages. 

In most countries, newly created jobs are of poor quality; there are not so many engineers or employees in the technical industry for example. The IT sector is not so buoyant, especially in the US. 

The new economic picture is based on bio-tech or new technology. And today it is difficult to know what the consequences could be for the whole economy. It means positive growth in the UK, for example, but what will the impact be in macroeconomic terms? That is important for bond markets. But today we don’t know, and that is the reason why the market is stable and positive.