The 'fog of war' that has surrounded the markets appears to be clearing. The wrangling over who gove...
The 'fog of war' that has surrounded the markets appears to be clearing. The wrangling over who governs Iraq may persist but for cynical financial markets the job seems done ' oil fields are secured, no weapons of mass destruction unleashed and uncertainty has been extinguished. Now we are surely back to fundamentals? Well, yes and no.
In reality, the paralysis that this conflict has inflicted upon bond markets had begun to crumble before a bomb was dropped. The sense of gloom had been preyed upon by speculative investors ' the easy trade was to follow the momentum of ever lower interest rate expectations.
This was especially the case in Europe where the European Central Bank was generally regarded as being 'behind-the-curve' and would need to play catch-up to avert a serious economic downturn. Almost by association, the UK market had enjoyed its own slice of this fervour ' though helped by the recent surprise cut (3.75% from 4.0%) by the BoE. So, effectively we have had two 'games' being played ' sliding equities encouraged the withdrawal of capital from cash investors (life companies/pension funds and so on) into lower risk assets ' namely short-dated bonds, while the speculative community seized upon the momentum behind this asset re-allocation (and doubts regards the economic outlook) to force short-dated bond yields down aggressively.
Like every good game, it gets progressively less enjoyable the more you play it. Hence with bond yields at a level barely justified even among the most fervent bulls there was always a vulnerability to a correction. The catalyst was the realisation that a conflict was actually happening. Therefore, a small surge in favour of the safety of the US dollar ' breaking the weakening trend of the previous year ' and suddenly everyone was holding just too many euros for comfort. In a trade where momentum is crucial ' especially for the speculator, who may well be borrowing to finance it ' everyone tries to exit through the same door at the same time. The door was never going to be large enough.
The front-end of European bond markets collapsed and suddenly it was all too obvious just how 'busy' a trade to lower European rate expectations had become. Hence the rapid 0.5% addition to five-year German bond yields to 3.5%. The key point to note throughout this is how little fundamentals changed. If anything, signs of further weakness across Europe have been confirmed.
Generally, bond markets have traded as a dysfunctional pack over the conflict ' too little cash investment, too much speculation. All this has been to the detriment of relative value between markets and asset types. So if we assume we are now moving into a post-paralysis period ' and we have had a shakeout ' what are the trades to own in bond world now?
Well, if one thing has changed over the last month, it is that the fog of the battlefield has crept into economic information ' particularly survey results which have generally nose-dived. Everyone appears braced for more sluggish demand or has been signalling more cautious investment intentions. How quickly these results turn around remains to be seen, but we continue to believe that the key medicine for recovery remains in place. As such, we are still approaching bond markets from a defensive stance.
Our preference to bond markets tends to follow the degree of stimulus we foresee being offered. Therefore, we view the US as the least favourable (very growth focused), then the UK (increasing bias to be growth focused, but restricted by explicit inflation target), through to a more positive view on Europe (still coping with the Bundesbank doctrine of snuffing out inflation and stagnant growth).
We have little strong opinion to offer on Japanese bonds other than when the global upturn is confirmed ' and a bear market develops in bonds ' they may well perform relatively well.
The bias to yield curves remaining steep continues. The US Fed needs this to aid recovery, the ECB will promote this with necessary rate cuts, while in the UK troublesome above-tar get inflation (>3.0%) and heavy government supply will undermine extremely thin conventional yields.
Inflation-linked bonds have been a favourite for us and will continue to be so. Ensuring recovery through low real yields is a must for Central Banks, while possibly playing fast and loose with inflation points towards a premium for protection. This environment implies a sweet spot for this asset class ' particularly in the US and the UK.
Investment grade credits remain favoured with the combination of equity investors rewarding deleveraging (so supply more limited) and bond investors hungry for extra yield. This has been the case so far and shows no signs of stopping in the medium term.
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