Thought of the day
07.07 - Dealing with the bond market sell-off
Global markets are again starting to anticipate higher interest rates, with the latest leg of the bond market sell-off driven by ECB minutes stating that "deflation has vanished." German 10-year Bund yields rose to an 18-year high, and were matched by similarly sharp moves in French (+10 bps) and Italian (+14 bps) yields. Swiss 10-year bonds have even flirted with offering a positive yield (having been negative for well over a year). The pace of the sell-off has begun to infect equity markets, with the usually-negative correlation between equities and bonds flipping into positive territory. Some categories of hedge funds may also have been affected, with risk parity and trend-following funds at risk of being caught out by the trend and correlation reversals.
We do not yet think the conditions are in place for a sustained surge in yields – or a major disruption for other asset classes. Inflation remains well below target in major developed economies, at 1.4% in the US and 1.2% in the Eurozone respectively. Central banks have stressed they are not in a rush to tighten: the BoJ has made clear that stimulus would not be withdrawn soon, and the ECB continues to emphasize patience and prudence. The recent sell-off has helped wash out market positioning, which is becoming less over-extended. US 10-year net long positions on the CFTC have eased from the decade-highs hit in early June. And past experience shows that periods of synchronized bond-equity sell-offs do not tend to last longer than a couple months (see the chart of the day)
Nonetheless, investors in diversified portfolios are likely to see higher volatility in the near term as bonds and equities move together, at least until the market finds a new equilibrium and correlations return to normal.
But there could be some beneficiaries that investors could turn to. The financial sector has been the best performing in Europe over the past week, and we still see scope for outperformance in both the US and Eurozone. A diversified holding of hedge funds can help reduce overall portfolio volatility at a time when equities and bonds move together, even if certain specific categories of hedge funds are caught on the wrong side of the trade. And shifting central bank policies are creating opportunities, in particular among some of the lesser watched currencies. For instance, we remain overweight the Canadian dollar vs. the Australian dollar, which this week has already begun to benefit from signs of diverging monetary policy.
So while the current period of bond market uncertainty could make things uncomfortable for investors, we do not believe it is yet significant enough to influence our tactical investment strategy, and investors have a number of means of insulating themselves from volatility in the meanwhile. We remain underweight government bonds and overweight global equities in our tactical asset allocation.