David Roberts

A return to the old normal?

David Roberts

The US Federal Reserve left interest rates unchanged overnight and the jury was out as to whether its accompanying comments were hawkish or dovish.

It is often better to look at market reaction rather than the comments of strategists and economists. To that end, risk markets had been softening in the run up to the Fed meeting. A combination of dollar strength, renewed trade war concerns and fears of further US sanctions against Iran pushed Emerging Markets (EM) lower – equity markets generally fell and the cost of protecting against EM sovereign defaults rose.

It is possible to suggest the Fed is in danger of moving “behind the curve” and starting to take a risk with inflation. That is, on some measures, interest rates may need to rise quite rapidly to prevent the economy overheating: wage pressure in particular is rising.

A benign Fed is normally good for equity markets: in the very short term, growth and inflation may be supported; longer term however, more interest rate hikes than anticipated may be needed to curb current excesses.

So far though, this seems to be an Emerging Markets problem. We always forget, (or choose not to remember) that EM economies are, in the round, heavily dependent on cheap, sustainable funding to permit excess growth and justify expanding earnings multiples. EMs should lead cyclical rotation but, of course, historically they lag.

Core bond yields are little changed and I would argue that if the market really does believe the Fed is acting too slowly, then we will see all yields move a little higher in the next few days. One thing we definitely need to watch for is the possibility the US curve steepens – that is long-dated bonds fall to a greater extent than short ones.

If that happens, that is a danger signal for risk markets – I have said many times that once the US curve stops flattening, we normally have around six months before risk assets properly roll over.

We started the week with a negative position in Emerging Markets – a 5% index level short – and that is working nicely. Against that, we have some core developed market (DM) high-yield assets and these are looking solid for now. If anything, I would increase the EM short in favour of DM, not least on a valuation basis.

We also have been adding a little to US interest rate risk, as yields at around 3%, even with the Fed a little behind the curve, offer a nice degree of protection. US bonds are also blindingly cheap relative to other markets.

We are now marginally long US bonds on most measures although short almost everything else – giving us a beta of about 0.7 compared with the global bond market.

To sum up then, we are short EM, long DM high-yield risk and long core US bonds, and short most everything else. Remaining short EM and expecting other DM sovereign bonds to fall relative to Treasuries clearly makes sense.

If we return to the old normal of nominal growth, bond yields and real returns all around 4%, then my predicted 3.5% high for 10-year bonds may be a little low.

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Thursday, May 3, 2018, 2:59 PM