Tim Haywood is the chief investment officer and head of the fixed-income division at the asset management firm GAM. And a few days ago he published some views that strike us as among the most reasonable to be found these days, when Bernanke has (further) thrown the financial world into turmoil. Tim essentially said the following: Bernanke has put the market under more strain than might have been expected. And this means that future communications from the Fed will become more delicate, more complicated to articulate and manage. Yet Bernanke’s statements were measured, logical and consistent. By contrast, the reactions of global markets were extreme and largely unfounded.
It seems that Mr Market cannot live peacefully without making contingency plans, without speculating on the next financial shocks or panics. Bernanke made it clear that he will buy bonds only until the US economy recovers in a sustainable manner, but that he will not stop doing so if the figures are not good enough. And, paradoxically, investors do not seem to feel comfortable with this overwhelming logic. Perhaps this is because some are becoming too jaded and had grown accustomed to straying from reason in this toxic environment.
What we are seeing now is nothing more than a market correction that is already pricing in this slowdown in asset purchases by the Fed for the third quarter of this year. And an end to purchases (turning off the QE tap) by the end of the first half of 2014. According to Haywood, the 10-year Treasury yield may still need to rise by a further 20 or 30 pips to reflect this scenario of the printing presses being shut down.
Economic figures from the US over recent months have been modest. Some indicators have been disappointing, but the property sector has posted strong figures. Another key factor for the forthcoming meetings of the Federal Open Market Committee (FOMC), which sets US monetary policy, will be the fact that the fiscal deficit is falling faster than expected. This could lead to a reduction in the volume of Treasuries issued in the coming months. However, any decline in demand for Treasuries could rebalance supply and demand without the need for a significant adjustment in prices or yields. Today, the Fed holds 29% of all US Treasury bonds, with this figure growing by a further 0.3% per month.
The first stimulus programme, or QE, was hugely successful. By contrast, the subsequent QE2, QE3 and Operation Twist failed to bring about an indisputable reduction in yields. QE is only partly responsible for bond prices; the future path of interest rates is a far more decisive factor for intermediate maturities. The reduction in the flow (until the programme ends) of bond purchases could affect yields by around 50 or 75 basis points, or even more if we focus solely on Treasuries, and the market has already priced in most of this in the falls seen over recent weeks. The FOMC is becoming increasingly united in its views on future rate rises. The greatest risk is that, over the coming quarters, the Committee will speak with an ever-stronger unified voice on this matter. However, it seems clear that the US economy is not growing at a sufficiently robust pace to justify an immediate and substantial rate rise. And that could cause the yield curve to steepen further, pushing long-term rates even higher.
With central banks ceasing their massive buying, the economy recovering, and barring any major unforeseen events, it is true that we could see rates of around 5% over the next 3 to 5 years. But in Europe, the situation is far more complex – which is saying something. The UNWTO They can only be vetoed by the German-Dutch-Finnish core; economic recovery is conspicuous by its absence on the periphery of the Eurozone; and the uncertainties are endless in a Tower of Babel of multiple election campaigns, changes and government coalitions teetering on the brink of collapse. A state of genuine, unpredictable chaos as far as the European outlook is concerned – extremely dangerous for investors.
US quantitative easing is being criticised by some central banks and praised by others. But all of them will, sooner or later, reach a point where they will have to start turning off the tap. And at that point, the traditional bond buyers will have to step in to prop up those markets once again. But of course, they will only return if yields become attractive again, because we mustn’t forget that After all this stimulus, over-indebted issuers are dangerously less solvent than before (Just ask the Spanish banks, which a couple of years ago were buying up Greek bonds by the bucketful and recommending them to their long-suffering customers.). But for creditworthy issuers, value is rapidly returning following the recent fall in fixed-income prices. US long-term TIPS are now offering a significant real interest rate of 1.2%, whereas just a week ago it stood at 0.4%. Brazilian 3-year bonds now offer 11% (4% above inflation), and Mexico, South Africa and other emerging markets with enviable economies have also reached tempting yields. These opportunities are clearly emerging, and they mean that future returns over the coming years are within our grasp – subject to inflation in emerging markets and the US. Have a go at it again with this interactive graphic which we linked to at the end of the article entitled «You have to choose between financial soundness and low volatility», and you will see that fixed-income investments, which are, on the face of it, more volatile, are also the safest option these days.
Ultimately, although some are up in arms because fixed-income yields are falling by as much as double digits (in the case of some emerging-market sovereign bonds), we are witnessing an essentially healthy trend. A gradual return to normality, from a situation in which fixed income was inflated by the constant and massive stimulus measures from the central banks of developed economies (emerging market debt yielded as much as almost 20% in 2012!). The unwinding will not be immediate, nor will it be easily contained – far from it – but it has already begun, and the markets are starting to price in the end of the insane money-printing sprees.
However, there is one thing we must bear very firmly in mind as investors. Debt issued by insolvent issuers can fall in price indefinitely and result in irrecoverable losses. By contrast, fixed-income securities from solvent issuers – such as a carefully selected range of companies and emerging markets – are currently offering very attractive double-digit future returns. The price to be paid is the declines – all of them temporary – that have already been suffered in previously purchased portfolios and any future declines that may lie ahead, as no one knows when yields will attract enough investors to reverse the falls.
But the safe haven of fixed income remains there, looming before us, with yields rising in line with falling prices. We await the day when more and more investors will reap the rewards that will come to fruition over the coming six-month periods.
It seems that fixed-income markets are causing more headaches than the stock market, and that the world is becoming increasingly chaotic. But perhaps what is happening is a sign of a new shift looming over markets that are overly influenced by monetary policies and the insolvencies of banks and governments across much of the West. And a shift in something that is already turned upside down may not be as bad as it seems, despite the panic felt by some.