|Bond Market Summary
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|Reference Indices (July)
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|Barclays US Aggregate
So What Do I Do with My Money?®
Rather than Gershwin, we sing Buffett (Warren, not Jimmy): “Be greedy when others are fearful and be fearful when others are greedy.” Low levels of volatility reflect investor complacency at the prospect of an increase in risk. Admittedly, we have held such sentiments for some time now, having moved several of our tactical recommendations to underweight. For credit sectors, those recommendations reflect a shift from an environment where credit markets provided ample cushion for risk to one where most spreads stand at or near pre-crisis lows, and where absolute yield levels for high yield bonds reached new lows in June.
We remain concerned that markets show too much complacency toward risk and maintain a more defensive set of portfolio recommendations for July. Specifically, we suggest raising liquidity and credit quality in a portfolio. In an environment of few attractively priced credit risk instruments, several areas gain in relative appeal: agency mortgage-backed securities, or MBS, (though absolute valuations look unattractive); Treasury and longer-dated Treasury Inflation Protected Securities (TIPS); and municipal bonds.
Summertime and the Central Banks are Easy
“There’s already great speculation about the exact timing of the first rate hike and this decision is becoming more balanced. It could happen sooner than markets currently expect.” —Mark Carney, “Speech at the Mansion House Bankers and Merchants Dinner”, Bank of England, June 12, 2014.
“So what can we take away from this picture? First, all the rules suggest that liftoff of the funds rate from the zero bound should occur next quarter. This is considerably sooner than many seem to be expecting.” —Charles I. Plosser, “Systematic Monetary Policy and Communication”, Federal Reserve Bank of Philadelphia, June 24, 2014.
The above quotes from monetary policymakers highlight the critical issue facing investors: How long until central banks begin normalizing interest rate policy? And associated with that question: What impact will that have on financial markets? The issue remains one for U.K. and U.S. markets, as those economies exhibit growth trajectories increasingly at odds with crisis-era policies. So what can we take away from this picture?
Philadelphia Fed president Plosser’s comments refer to Figure 1. Here we plot the current market expectations for U.S. monetary policy against two indicators of potential monetary policy paths: 1) that implied by the median of FOMC participants themselves from the Statement of Economic Projections (SEP) and 2) that implied from a set of standard monetary policy rules1.
The current market pricing of Fed policy rates stands well below these other potential (and higher) interest rate outcomes. Either the market doesn’t believe the Fed’s projections, believes that the real Fed policy is more reflective of the most dovish participants’ views or the market has the pricing wrong and needs to reprice towards higher interest rates in the short end of the curve. All are plausible explanations and outcomes for the discrepancy.
Figure 2 highlights how this discrepancy has evolved over time. The market now expects an even longer period of ZIRP than that suggested by the FOMC SEP. Coming on the heels of the June FOMC statement and press conference, that shift likely reflects the markets belief in a very dovish Fed Chair dominating over the views of hawkish members, who subscribe more to a policy path prescribed by the standard rules highlighted in Figure 1.
What’s the Outlook for the 10-Year Treasury?
You are asking the wrong question. ZIRP is the defining characteristic of the post-crisis bull market across all asset classes. And when it wasn’t enough, the central bankers added some quantitative easing spice to their policy soup. For fixed income investors, last year’s bond market performance was about the exit from quantitative easing that is happening this year. This year’s bond market performance will be more about the exit from ZIRP next year.
As Governor of the BoE, Mark Carney’s Mansion House speech had notable effects on the markets. Meanwhile, as minority voices or non-voting members of the FOMC (and viewed by the market to have little influence over actual policy outcomes), the regional bank Presidents’ comments brought little market reaction. Figure 3 shows the U.K. and U.S. bond market reaction to Governor Carney’s speech. As in the market reaction to Fed Chair Janet Yellen’s inadvertent warnings of faster increases in policy rates back in March (her “six-month” answer to the question of how long would constitute a “considerable” period), the area most affected by shifting expectations around policy normalization was the front end of the curve (yields of shorter-maturity bonds).
That behavior again provides a reminder of the risks facing fixed income investors. Rather than a repeat of last year’s “taper tantrum,” where fixed income yield increases are led by the back end of the curve (longer maturities), we anticipate the front end of the curve will be most affected when the Fed (or the BoE) signals raising policy rates. And what is critical to keep in mind is that because bond markets are both forward looking and prone to overreact, and illiquidity in fixed income markets can exacerbate those overreactions, a small shift in market expectations can lead to unexpectedly large price moves. The potential overreaction to the Fed (and the BoE) exiting zero interest rate policy in 2015 stands as our key concern for 2014.
Nevermind the Bullards…
As mentioned above, the market generally ignores the hawkish sentiments expressed by regional Federal Reserve Presidents, as they are thought to carry little sway over policy decisions. If so, then the critical issue is what, if anything, might change the Chair’s viewpoints on maintaining such accommodative monetary policy for so long? The answer Chairwoman Yellen has provided on numerous occasions: faster and more complete healing of the labor market.
To this end, our colleagues in BlackRock Fundamental Interest Rate Strategy put together something we call the “Yellen Index.” Based on her recommendations for what constitutes a more “robust” measure of the labor market (relative to the single measure of the unemployment rate), we quantify a broader measure of labor market conditions. See Figure 4.
The measure highlights the recovery in labor markets based on Chairwoman Yellen’s recommendations for a broader array of indictors. These include long-term unemployment and underemployment rates, payrolls and household employment measures, and data from the JOLTS surveys capturing job openings and measures of job turnover.
What is missing from the labor market that keeps the Fed on a persistent path of zero interest rates? And, by implication, what is critical to alter this path in the mind of not just the Fed, but firstly, in the mind of the market? Clearly it is the debate over long-term unemployed and the structural factors impeding their faster return to the ranks of the employed. Hence, this topic will be discussed at the annual Economic Symposium Conference at Jackson Hole at the end of August.
So What Should I Do With My Fixed Income Portfolio?
In today’s fixed income environment, investors (and their advisors) face a trade-off between the goals of income or principal preservation. The opportunity to achieve both with the same instrument at the same time no longer exists. That results from the persistence of ZIRP in the developed markets leading to a lack of “safe” bonds with positive real (after-inflation) income.
For a time, private credit markets offered investors some refuge. Today, however, tight credit spreads reflect not only a benign outlook for default risks, but also a benign outlook for volatility. And low levels of volatility imply little need to change portfolios, and hence, little need for market liquidity. But the resulting low level of liquidity risk premium (i.e., the discount in bond prices for bonds that trade infrequently and/or with high transaction costs) reflects another risk to future bond performance. As the BoE itself highlights, it is the persistence of global central bank policy accommodation that underlies the low levels of volatility and leads investors to undervalue the liquidity risk in their bonds2. The implication is that the normalization of policy rates will lead to a reversal of such trends. And the result is higher volatility, increased liquidity premiums, and lower bond prices.
When faced with the trade-off between income and preservation of principal, we tactically favor erring a bit more on the side of preservation strategies. That means moving up in liquidity and credit quality. Our sector recommendations reflect this perspective, with relatively more favorable viewpoints on agency MBS, Treasuries, TIPS and municipals vs. corporate bonds, bank loans and high yield. Emerging markets presents a mixed picture, with dollar sovereign credit sectors equally vulnerable to spread widening under our central bank policy normalization scenario, but select local currency markets offering a better degree of cushion when paired with appropriate foreign exchange hedges. Securitized credit—commercial MBS, collateralized loan obligations (CLOs) and asset-backed securities (ABS)—represent areas of illiquid exposures, but the valuations of selected exposures make for more attractive sources of income.
The challenge of such a defensive strategy is that its benefits aren’t realized until the return of a higher degree of market volatility and liquidity risk premium, yet its costs (in the form of lower income) are recognized up front. Admittedly, the lack of any particular catalyst presents the risk of continued underperformance of such a defensive strategy.
Our main concern remains that of mispriced interest rate expectations and the potential for overreaction in the credit markets once that mispricing is revealed. But if global central bankers’ stance continues to ignore the data (or our forecasts for economic improvement in the U.S. and U.K. turn out wrong), then such a defensive strategy will prove overly so.
The cost of such an error is the forgone income along the way. However, we believe the reduction in future price declines with a more defensively positioned portfolio far outweighs this loss in income. Such a strategy requires patience that admittedly appears harder and harder to maintain in the face of persistent expectations for zero interest rate policy fueled by policymakers’ insistence on zero-cost ZIRP.