This latest sell off in the bond markets has many investors wondering if there has been a bubble in the debt markets that is finally bursting. After decades of a bond bull market, and six years of central bank liquidity measures, are we finally going to witness a move higher in rate structures across developed economies? That is a hard question to answer, and probably too early to call. The important things to focus on are the potential drivers of the price action, and what if anything, has fundamentally changed. This has been the hot topic of debate in our strategy meetings and I’ll try to summarize the ideas of the group.
Ultimately, this appears to be a story of unwinding crowded positions exacerbated by mildly better than priced fundamental data. Consensus has been building across most asset markets for over a year, whether it is oil, the dollar, developed market rates, or the periphery in Europe. The sense from the group is that as consensus was reached, there were few new entrants into positions at stretched valuations. A market left with only holders or sellers.
The consensus trades of the last 12 to 18 months fit into three broad macro themes and the interplay between those themes: (1) the divergence in US monetary policy with the other major central banks in the face of clear deflationary forces – this has had implications for both currencies and commodities as well as rates markets, (2) the supply and demand imbalance between the net supply of bonds and the demand for bonds – which has had a meaningful impact on rates across developed economies and credit markets, and (3) the expectations for end game in the periphery, most notably crystallized in the “Grexit” drama.
From a fundamental perspective, little has changed in the U.S. or in Europe since early April. The U.S. continues to expand at a moderate pace with growing wage inflation pressure, and Europe is showing very modest signs of economic growth and inflation. If there is a common trend here, then it is the diminished momentum of disinflationary forces in the near term. This could be a driving factor behind the increases in TIPs breakevens in the U.S., and longer term bond prices in both the U.S. and Germany. This logic sits well with investors focused on the fundamentals, given that the pricing of disinflation into yield curves was the best fundamental explanation for the nearly monotonic rally in developed market rates since December 2013.
What seems to have changed more than the fundamentals is the market’s perception of the economic data, and its reaction to stretched valuations. This shift in psychology could easily explain the change in market pricing of the same facts given the pressed technical backdrop and low liquidity environment (volumes have been fairly low given the extreme moves). This logic may be less satisfying for the thoughtful investor, though Occam’s razor certainly points in its direction.
We have seen very similar price action following the announcement of QE-like policies, similar to one announced by the ECB at the turn of the year. Markets rallied leading up to the earlier QE campaigns announced by the Fed as investors begin to incrementally price in the policy measures, only to retrace to higher rates within 6 to 12 months after the announcement. So, although this recent move higher in rates could be seen as reminiscent of the Taper Tantrum in 2013, it is eerily similar to experience surrounding QE2 and QE3 in the U.S. In both of these cases the market reverted towards lower rates and tighter spreads after the transitory correction.
All things considered, it is still too early to tell if this month’s moves in global bond markets signal that the lows in global bond yields have been seen – the “big one” for career bond investors. However, the long term trend lower in rates is very well entrenched, and the combination of a deleveraging developed world with an aging and de-risking investor base remains.
The best strategies within the fixed income markets for those unwilling to take a strong directional view on rates here continues to focus on diversified global bond exposures. Ideally, the portfolio would include enough credit spread exposure to absorb rate moves higher and benefit from improving economic fundamentals, combined with some high quality “duration” to provide ballast in periods of crisis, downturns or reemerging perceptions of deflation.