A sharp rise in US bond yields has triggered a similar rise around the world but this has not been...
A sharp rise in US bond yields has triggered a similar rise around the world but this has not been enough to dampen the enthusiasm of fixed interest managers for their asset class.
Merrill Lynch chief global fixed income strategist Thomas Sowanick says there is significant risk of higher US yields and believes a move toward 10-year Treasury yields of 5% by year-end is a distinct possibility.
'Though the Fed has clearly encouraged investors to believe that incremental easing is still a possibility, it has also been quite deliberate in discouraging investors from believing that quantitative easing is just around the corner,' he says.
Sowanick adds the market has now taken back the rallies of early May and early June and is now sitting at a crossroads.
'Though our base case expectations for lower yields in Europe are being challenged, we have taken the rise in eurozone yields to add to our already overweight position. Just as the eurozone represents the best risk/reward tradeoffs, we believe the US represents the worst risk/reward characteristics,' he says.
While Sowanick feels there is fundamental support for a 75 basis point easing from the European Central Bank (ECB) by the end of the year, the market has only priced for 10 basis points, which suggests a substantial rally at the front-end of the eurozone bond curve if he is proved correct.
Further strength in the euro against the dollar would also support the case for an ECB easing, as the central bank would need to be quite aggressive to offset the tightening effect of a stronger currency on economic activity, Sowanick says. While all markets will find it difficult to improve on a real basis if US 10-year yields approach 5%, Sowanick adds he is hopeful that the eurozone will be able to buck what may become a trend to higher yields.
Short-term yields are also likely to be protected from any rise at the longer end of the curve, he says.
'Curves will need to get much steeper before this cycle is over. Nearly every central bank is concerned with the risk of disinflation turning into deflation,' Sowanick says.
Henderson fixed income manager John Patullo says the sell-off in bonds seen since the Fed's June rate cut suggests duration, or interest rate sensitivity, is a greater risk to most bond funds than default risk. 'US 10-year Treasury bond yields have risen from a low of 3.1% in mid-June to the current 3.95%. This is a capital loss of 6.8% and equates to most funds' annual running yield,' Patullo says.
'We believe in the short to medium term, bonds yields are like to continue to edge higher. Over the longer term, however, we continue to be concerned about structural imbalances affecting the world economy.'
Accordingly, the best returns in future will come from low duration, higher default-risk funds, he says.
While he feels it is misleading to speak generically about the end of the bond bubble, Patullo says we could be at a turning point in the market's perception of the interest rate cycle.
'For several years, the best returns have been from funds with long duration and low default risk. Last year much of the return in investment grade bond funds came from falling gilt yields and rising prices rather than from holding credit,' he says.
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