17th February 2015
Stuart Edwards, fund manager of the Invesco Perpetual Global Bond Fund, discusses the challenges and opportunities that recent events could provide for investors…
2015 is already shaping up to be an interesting year for financial markets, with the oil price falling, the Swiss National Bank ending its peg on the Swiss franc against the euro, the European Central Bank (ECB) implementing large scale quantitative easing (QE) and Greece electing Alexis Tsipras as Prime Minister to lead an anti-austerity coalition. Against this backdrop, bond yields have fallen sharply and volatility in the currency markets has risen.
An update on the bond markets
The most important factor driving bond yields lower over the past few months has been the decline in the oil price. Whilst lower oil prices can provide a stimulant to the economy through lower input costs, the market’s focus over the past six months has tended to be on its disinflationary consequences. The positive impact on purchasing power of falling inflation is clearly good for assets paying a fixed level of income, such as bonds. In the UK, and to a lesser extent in the US, lower inflation has helped to push out expectations of interest rate hikes. In the Eurozone, the sharp fall in oil prices increased deflationary pressures, but also enabled the ECB to address this problem by announcing the implementation of QE through large scale bond purchases. The measures announced were greater than the market expected both in terms of total amount and tenure of bonds to be purchased.
The impact of the ECB’s decision to implement QE was not restricted to the bond market; it also added to selling pressure on the euro and indirectly raised volatility in the currency markets. The trend for a weaker euro has been further compounded by the uncertainty surrounding the Greek election. Expectations that a much weaker euro would lead to a surge in demand for the Swiss franc was widely viewed as the reason the Swiss National Bank (SNB) unexpectedly decided to abandon the Swiss franc’s peg to the euro ahead of the ECB’s QE announcement. This surprise decision saw the Swiss franc immediately strengthen by over 20% against the euro, closing the month of January up around 13% (Figure 2). The market has now turned its focus to the Danish krone, which is currently pegged at a rate of 7.46038 against the euro, with a 2.25% band either side. In order to try and defend this peg the Danish Central Bank has been active in the currency markets and has twice cut its benchmark deposit rate (the rate banks receive on deposits) to -0.35%. Volatility has also spiked higher in the currencies of countries with high oil dependency. For example, the Norwegian krone and the Canadian dollar have both fallen, with the weakening compounded by monetary easing as their respective central banks attempt to protect growth.
With the ECB joining the Bank of Japan in embarking on QE, the scope for a significant near term sell-off in core government bonds is, in my view, limited. That being said, I do not believe in the Japan-type deflationary scenario that core government bond markets seem to be pricing in. Core government bonds are, in my view, due a correction and if the US Federal Reserve (Fed) does, as some think, start normalising monetary policy this year we could see bond yields come under pressure. However, what will eventually trigger the structural higher move in yields is uncertain, with historical analysis suggesting there is not always a specific tipping point, rather a culmination of factors. Given this uncertain backdrop, and the poor level of compensation core government bonds currently provide for the duration risk, I prefer to take opportunities elsewhere and maintain a low duration position. Indeed, if government bonds rally from these levels it could, in my view, provide an opportunity to further reduce duration.
The start of QE in Europe will see the ECB and Eurozone national central banks together become a very significant buyer of peripheral sovereign debt. In total they will be buying €60bn a month of both private and euro government bonds (except Greece) until at least September 2016. Of the sovereign bond purchases 20% will be undertaken by the ECB with the remainder purchased by national central banks. The scale of the purchases is large. Barclays estimate that sovereign purchases will equate to around €45bn a month, or around €550bn annually compared to annual net issuance by euro governments of around €220bn. The scale of this programme should provide further support to both core and peripheral sovereign markets with the spread between peripheral and core Europe, in my view, likely to tighten. It is also worth noting that across the periphery structural reforms are starting to gain traction, which should further help government funding costs. Ultimately, the lower bond yields get, the more self-sustaining peripheral government financing should become. I am aiming to exploit this tightening through exposure to Italian, Spanish and Portuguese government bonds.
Following the precipitous decline in crude oil prices, the market’s price of inflation, as expressed through breakevens (the difference in yield between conventional government bonds and inflation linked government bonds and a widely used valuation metric for inflation linked bonds) has fallen markedly. At these levels I think that inflation linked bonds are starting to look attractive. However, I am cognisant that with the return on these instruments tied to the level of realised inflation the current low level of inflation means a significant movement in price is needed to make holding inflation linked bonds worthwhile. Taking note of this, and the other headwinds that the market is pricing in, including a potential hike in the Fed Funds rate and the rising US dollar trend, I think that a stabilisation of the oil price could start to create opportunities in this space. As a long term theme, I have therefore, been building exposure and continue to monitor levels closely.
One of the big trends of 2014 was US dollar strength. Although we have already seen a significant appreciation of the US dollar, when compared to previous cycles we think that we could still be in the early stages of a multi-year trend: The US economy is performing well, especially when compared to other regions, and the likely divergent monetary paths of Europe and the US should continue to provide support to the US dollar. The decision by the ECB to implement QE is likely to add further support for this position. It is a similar story in Asia where the Bank of Japan’s own QE program is helping to depress the Japanese yen (Figure 4).
That being said, it would not be surprising to see the US dollar consolidate for a while, thereby providing some more tactical short term opportunities around the long term trend of US dollar appreciation. At the start of October I took the view that the US dollar had become stretched against the Japanese yen and decided to tactically sell the US dollar for Japanese yen.
This view proved correct, with the Japanese yen rallying until 16 October 2014, at which point I took profits. I would expect that similar tactical opportunities will present themselves in 2015.
Sterling currently faces a number of headwinds, including uncertainty about the upcoming UK general election and the fact that the first UK interest rate hike is now not expected by the market until early 2016. Against this I think it is worth remembering that UK economic data is actually reasonably robust and that the market might have over-reacted to recent data in pricing interest rate hikes. In my view, while sterling faces a number of challenges we could see it start to strengthen from current levels and so I am watching levels closely.
Countries whose economies are closely tied to commodities have seen a sharp depreciation in their currencies. For example the Norwegian krone, the Mexican peso and the Canadian dollar have all fallen. In some cases I think the movement has been too extreme and I am looking to tactically add exposure. However, with such positions I need to be cognisant of the impact of central banks, which have cut interest rates to help protect their economies.
Overall, I think the pattern for this year will be for more volatility in both the interest rates and FX markets. As QE continues to squeeze out value across the fixed income investment universe, we believe it will become increasingly important to be flexible and use tactical opportunities to supplement core positions and diversify risk away from them.