The first cut is the deepest

US Treasury bond yields rose sharply this week. That should make us more bullish on bonds. After all, you get paid more for owning fixed income now than at any other time in recent years. More than that, higher yields protect a portfolio from price volatility much more so than they did when yields were depressed by global central bank buying. Of course, they are higher in the US because the economy is booming and the Federal Reserve (Fed) is raising rates. The risk is, for those reasons, yields go higher. But the total return hit gets less as yields do move up and at some point, when the risk cycle turns, investors will be glad of the fact that they own fixed income. Especially in US dollar denominated portfolios. The dynamic may be the same in Europe, but ultimately bond yields have further to rise and they are starting from a lower base. For that reason it is not as easy to be as bullish on European fixed income.                                          

Reflation happened

I remember the day after Donald Trump was elected President of the United States, I wrote a quick email to my colleagues and to clients suggesting that we should see markets react to what would clearly be a reflationary set of economic policies under the new Administration. US Treasury bond yields rose in anticipation of a more aggressive fiscal policy and a commensurate response from the Fed. The policy rate was just 0.5% at the time. Bond yields rose above 2.5% but then spent a year going sideways as there were doubts over how much of a fiscal boost would be forthcoming given the Administration’s problems in trying to get health care reform through Congress in the first part of the Trump era. This year taxes were cut and the economy has roared in response. Already this month we have had more strong reports on both manufacturing and services from the Institute for Supply Management (ISM), the ADP survey on employment showed very strong jobs growth, continuing unemployment insurance claims are running at cyclical lows and durable goods orders were up 4.4% on the month in August. Growth might be slowing in emerging market economies that are facing a period of fiscal and monetary restraint and increased financing costs, but in the US current growth numbers are stronger than most people anticipated.  

Strong growth and tightening policy  

It’s relatively easy then to justify the sharp move higher in bond yields this week. The 10-year benchmark hit 3.2% on Thursday, the highest for seven years. The strong data and comments from Fed Chairman Powell that short-term rates are probably not at neutral yet were behind the move. But let’s not forget, yields have been moving higher since July 2016 and have got higher with each piece of data suggesting the economy is at full capacity and that the Fed may have to raise rates by more than the market is currently pricing in. Real yields have risen more than inflationary expectations and there are some potential explanations for that – the decline in the Fed’s balance sheet, revisions to estimates of where the long-term neutral rate is, and perhaps even to potential growth. So far, inflationary expectations have failed to rise with the break-even inflation rate on 10-year TIPS at 2.17% at the time of writing and within the range it has traded in all-year. Yet I would not be surprised to see either higher oil prices or an upside surprise on wage or price data push those inflationary expectations higher. No-one knows when the reflation will fade and when growth will slow but even if the consensus for lower growth next year is correct, there is little evidence of it happening just now.

Is 4% on the horizon?

Most people in the bond market are reluctant to forecast significantly higher yields because yields haven’t been high for a long time. Yet a yield of 4% at some point in the next few months would not surprise me. Ultimately they may rise even more than that, who knows (but at the moment I find it hard to see it). The technical picture for treasuries is not great, given the slow rolling off of bonds held by the Fed, the increased borrowing requirement of the Treasury to fund the budget deficit and the unattractiveness of US bonds on a FX-hedged basis for foreign investors (the 10-Year US Treasury yield would need to be some 50 basis points (bps) higher to make it attractive to European investors whose default risk-free asset would be the 0.5% yielding German bund). Admittedly, there is strong demand for the long end of the US market from US pension funds, helping to explain why, on balance, the curve remains flat. The risk is though, that the upside to yields has been opened up by the market breaking through ranges that have been in place for some time. I am not forecasting 4%  but I am saying it is a possible scenario in an economy that is experiencing nominal GDP growth of more than 5% in 2018.

Cheap is good

Of course, the higher US yield goes, the more bullish I become on US fixed income. Higher yields tend to reduce the duration of bonds so the risk to capital of each incremental increase in yield gets smaller. Two years ago, taking the ICE-Bank of America US Treasury Index, a 50bps increase in yields would have resulted in a 3.3% capital loss and, annualised with the prevailing yield at the time would have meant a total return of -2%. A similar 50bps move today would leave the total return on the index flat. There is more cushion from current yields and less sensitivity (the index duration is around half-a-year shorter) than there was in 2016. For the US investment grade credit index the difference in total return from a 50bps increase in yields would have been +1.4%. In Europe, where yields remain very low, a 50bps increase in the yield on the European government bond index would still result in a total return loss of 2.8%. When yields are super low and start to rise is when returns are the most negative. Indeed, between the middle of 2016 to the end of that year, the total return of the US Treasury index was -4.9%. This year it has been -2.3% with income contributing a positive 1.7% and the price effect being less because of the lower duration of the index now compared to 2016. We are through the worst of the US bond bear market.

Still concerns, but shorter dated US bonds are attractive

So at 3.2% yield it is more comfortable to be bullish on treasuries than it was when the yield was below 1.5%. For the pure 10-year exposure, an increase in yield to 4% from current levels would still result if a sizeable negative total return of just under 4%. But that compares with a loss of 4.4% (for a comparable yield move) six months ago and over 6% from the low in yields in July 2016. Remember that the US curve is very flat, there is only a 30bps difference in 2-year yields compared to 10-year yields, so being more bullish on US fixed income is probably better played out in the curve below the 10-year maturity mark for now. But should yields get to 4% the longer end would look much better. Not only because of the yield but because of what it would imply next.

Rates up then credit spreads wider

A potential playbook or roadmap for the end of the fixed income cycle is the one where real yields and rates rise because of strong growth and an appropriate monetary policy response to the increase in inflationary pressures. In turn, higher real yields start to have a negative impact on risk assets. First, the risk-free rate becomes a competitive asset so riskier alternatives need to re-price accordingly. Second, higher real yields will have some impact on the real economy through increasing the cost of capital and making some investment projects unprofitable, not to mention increasing debt servicing costs for the indebted parts of the economy. As economic growth slows it becomes harder for equities to keep delivering growth and reduces the ability of companies, at the margin, to service their debt. Thus risk premiums need to rise and risk assets will underperform risk-free rates. When the economic slowdown becomes evident, the market will price in and eventually get lower interest rates, boosting the return to fixed income. 

Don’t be too bearish, it’s rates

This line of thinking means that as Treasury yields rise investors should become more bearish on credit and more bullish on rates. Seems coincidentally contrarian but it makes sense on a forward looking basis. Global credit spreads are wider this year, but apart from in emerging markets, not by that much. Nor should they be given the positive macro backdrop and the strength of corporate balance sheets. Credit has actually outperformed in the last 3 months (globally and individually in the major investment grade markets of the US, Euro and sterling). The move of credit spreads significantly wider and rates lower is probably some way ahead of us and would need equities to start underperforming before it happened in earnest. However, it is on the horizon and in the short term it could be mimicked by the sensitivity of markets to ‘risk’ events. The Italian story gave a sense of this last week. The ratcheting up of US-China trade tensions might do it. Investors might already be looking at US yields above 3% and thinking “not bad for a safe-haven asset”, when equities are subject to abrupt changes in the fundamental outlook at the stroke of a presidential pen. The recently re-emphasised ‘national security’ complexion to the US-China issue should be a worry for investors.

October ?

Credit-default swap spreads for emerging markets, US high yield and European crossover credit have moved higher in recent sessions, suggesting that risk-off is revving up a little. October is one of those months when strange things happen in markets. Although I am not a believer in those kinds of weird market ‘memes’, enough investors may be such that volatility increases into year-end. It’s been far from a vintage year in fixed income and it seems very unlikely that adding further to high yield or credit exposure at this stage would make a huge positive difference. It’s clearly not the same picture in Europe compared to the US but the dynamics could still be the same if there is a risk-off episode. All else being equal, the sell-off in global bonds since the middle of August and the recent lurch higher in US Treasury yields in particular should make investors think about having a little bit more safe haven fixed income in their portfolios.

Where’s the glory?

Rationalising movements in the bond market is pretty tough but I feel far more comfortable trying to do that than trying to understand what is going on with Manchester United. I can’t believe that the players don’t care (although comparisons with previous generations would lead one to that view – Keano, Bruce, Gary Neville) or that they are generally of lower quality than that of the teams they have played recently (Wolves, West Ham, Valencia). Yet something is going badly wrong. Is it tactics? Is it player-management? Is it that this group just doesn’t have the natural chemistry to gel on the pitch? The fans are more frustrated now than at any other time since Sir Alex retired, and that is saying something, given the dire state of play during the Moyes and Van Gaal years. As an investor I would look right to the top and question the business model, because it is not delivering in its core function – winning games and trophies. I just hope something is done to prevent United replacing Liverpool as the big fallen great of English football.

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