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Fixed-income market perspectives

The big unwind. Where now, Mr. Draghi?

During the last three weeks we have witnessed the sharpest move in developed-market rates since the then Fed Chair, Ben Bernanke, announced the end of quantitative easing (QE) in May 2013. In an environment which was then (and remains) highly influenced by central-bank bond-purchase programs, the market’s reaction then was very rational. It also demonstrated how difficult it would be for central banks to move back to a more normal policy regime without causing considerable and economically costly market disruption.

This time the selloff was driven by 10-year Bund yields, which moved from around 5 basis points (bps)1 in mid-April to 78 bps2 in mid-May. The move spilled over onto the U.S. and U.K. markets – causing, for example, 10-year U.S. Treasuries to rise to 2.3%. All this happened without any statement or hint from the ECB that it might change course.
There have been some headwinds from European macroeconomic data, supporting the picture of a slow recovery, and fears around Greece are fading. But these factors are hardly strong enough to explain such a strong rise in interest rates and, in particular, why the ECB did not step in quickly to keep rates low.

Other factors, such as the extreme long positioning both in German government bonds and in the U.S. dollar (vs. euro), the unwinding of those positions to protect year-to-date gains, the lack of demand from real money investors at such low levels and the lack of liquidity may have reinforced the upward move. But, again, they provide no reason for the ECB’s lack of action.
One possibility – out of several – is that the ECB wants to mute the effects of QE, but cannot admit it. QE is causing a number of problems, not least for pension providers. It is also adding to concerns about future asset-price bubbles.

As a consequence, European interest-rate lows may now be behind us. However QE, low inflation and anemic growth should support rates at current levels or possibly drive them slightly down again from their current, post-adjustment levels – at least until the ECB formally changes course. This remains the biggest risk factor for markets.
U.S. rates over the next month are likely to be driven mainly by domestic factors (U.S. growth, inflation and oil prices) and the Fed’s reaction to them. We believe that the U.S. economic recovery is still underway, even if it is not as strong as had been widely expected. But keep an eye also on Chinese central-bank actions, which could also be an important key driver for U.S. rates. For longer-term rates, we have a bias towards being long.

For foreign exchange (FX), we expect some consolidation at current levels and a further strengthening of the U.S. dollar vs. the euro and Japanese yen toward the end of 2015.
Corporate credit (investment grade and high yield) remains well supported over a medium-term horizon.

10-year government bond yields, 2014-15

Core developed-market yields moved up again in May. The German reversal was particularly sharp.

ref-1

1 As of 4/17/15

ref-2

2 As of 5/14/15

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