A dovish Fed tightening that raises more questions than answers


Fund Commentary
19 Jan 2016


In December, all eyes were focused on central bank meetings, expecting a massive bazooka shot from Mr. Draghi on 3rd December and a cautious tightening by the Fed on 16th December. The FOMC revealed no surprises with a first rate hike in almost a decade (Fed Funds from 0%-0.25% to 0.25%-0.50%) and a relatively dovish comment by Chairman Janet Yellen signalling gradual tightening in 2016 and confirming that the size of the Fed’s balance sheet will not decrease “until normalization of the Fed Funds rate is well under way”. The surprise came from the ECB, but more precisely from the markets’ reaction to the ECB’s decisions. Apparently, they expected too much from Mr. Draghi, probably due to misinterpretation of ultra-dovish speeches from ECB’s members before the meeting. Mr. Draghi actually did the job, cutting the deposit rate from -0.2% to -0.3%, extending QE for 6 months (i.e. 6×60 billion EUR = 360 billion EUR) and adding Municipal and Regional bonds to the QE purchase list.

The markets did want an “extend + expand” of QE and their disappointment led to a mini-sell off in the European Government bond market that spread to US Treasuries. Due to this exceptional Central bank activity, all other news faded into the background. There was mixed economic data in the US with steady improvement in the job market offset by poor industrial production and ISM manufacturing (reaching the lowest level since June 2009) and in Europe, more signs of economic recovery in Spain and Italy but gloomy French data and possible political instability in Spain after elections that led to no clear winner. In this respect, the widening of only 20bps of the spread Bono-Bund seems too small.

In this context, the 2y US Treasury yield increased from 0.93% to 1.05% (+12 bps), the 5y yield from 1.64% to 1.76% (+12 bps), the 10y from 2.21% to 2.27% (+6 bps) and the famous 30y long bond from 2.97% to 3.01% (+4 bps). This bearish flattening pushed down the 5-30y spread from 133 to 125 bps (vs 140 in October) and the 2-30y spread from 204 to 196 bps (against 220 in October). On the credit side, the US corporate CDX index kept widening from 84 to 88 bps due to the first signs of recession in some sectors of the US industry and the European iTraxx Main widened from 70 to 77 bps, led by some disappointment after the ECB meeting. Many investors thought that some corporate bonds could have been included in the QE purchase list had the decision been made to expand QE from EUR 60 to 80 billion EUR per month. 

In December, The Investment Adviser did not change the strategy he has been following since June, favouring high quality and liquidity. The only transactions that have been made this month were sales of government-owned corporates and agencies (KfW, EDC, EDF, Rentenbank and Temasek) in order to decrease their weight from above 5% to below 5% of the assets. In terms of duration and duration overlay, the Investment Adviser maintained the modified duration of the Fund above 4, reaching 4.15 at Year end.
The Investment Advisor believes that the ECB will stay ultra-accommodative and that Mr. Draghi will announce an increase of the ECB’s QE in the coming months. The economic conditions are not particularly improving in the Eurozone with low growth and, more importantly (as it is the unique mandate of the ECB) zero inflation. Growth is a concern because the current conditions are disappointing despite the alignment of planets (low euro, low yields, low oil & commodity prices and the ECB’s QE). Regarding the Fed’s policy, the behaviour of the FOMC in 2016 is unclear: inflation is low, international issues are growing (Emerging markets, China in particular) and the Fed is expecting four rate hikes (25bps/Quarter) while markets only forecast 2 hikes (the 2y Treasury note yield reached 1.05% which is too low compared to the Fed’s dot-plots). One of the key drivers of markets in 2016 (both bonds and equities) will be Forex: the currency war is still in place as many central banks are still in ultra-dovish mode, including China and Japan. The dollar index (Bloomberg ticker DXY) is more than ever the major factor to follow and the weakening of the Yuan could lead to a less hawkish Fed behaviour and a more dovish ECB.

The Fund Manager is still extremely cautious on corporate spreads and on liquidity of the credit market. He will continue to focus his investments on high quality corporates and government agencies. High beta names will be avoided except very short maturities with a “buy and hold until maturity” strategy. High Yield and Emerging Markets will be avoided and the remaining Middle-East position ($ 1 million Mubadala Abu Dhabi) will be sold in January 2016 once liquidity returns. The modified duration of the Fund may be maintained between 4 and 5 and the 30y Treasury position, partially hedged by a short 2y and 5y US T-note will be the key driver of the behaviour of the Fund in 2016. The Investment Advisor will consider investing in 30y TIPS (Inflation-linked Treasuries) but the timing of the investment will depend on the evolution of the inflation break-even of these bonds. The Fund Management team still believes that positive returns will be achievable as a result of the carry of government-owned bonds and high-quality corporates, their spread tightening potential, credit selection and active management of duration and yield curve.

The views and statements contained herein are those of Sturdza Private Banking Group in their capacity as Investment Advisers to the Fund as of 14/01/16 and are based on internal research and modelling.