Fed: the markets are ready for a dovish tightening


Fund Commentary
17 Dec 2015


In November, the markets were looking for clues in central banks behaviour (their speeches in the media, in particular) before the ECB meeting scheduled on 3rd December and the FOMC decision on 16th December. With China remaining a major issue and Emerging Market economies still suffering due to record low commodity prices, global growth remained a concern. Terrorist attacks in Paris added stress in both markets and the European population. In this gloomy environment, the good news came from Argentina and its new President, Mr. Macri.

In the US, economic statistics were encouraging, led by the non-farm payroll number which reached +271k (unemployment rate 5%). In addition, the first signs of wage inflation appeared. PPI (-0.4% this month, -1.6% yoy) and CPI (0.2% this month and 0.2% yoy) were weak but ex-food and energy
numbers were more in line with the Fed target (PPI +0.1% and CPI + 1.9%). Q3 GDP (annualized qoq) reached 2.1%, revised up from 1.5%. The only disappointing data was consumer confidence, falling from 99.1 to 90.4. Consequently, the probability of a Fed rate hike in December increased dramatically (to above 70%).

In Europe, moderate German data was offset by the Spanish, Italian and French recovery (with a surprising Q3 GDP figure reaching +0.3% in France). Mr. Draghi and other ECB members confirmed that the ECB may expand its QE policy if current market conditions continue to weigh on inflation. As a consequence, the ECB is more than ever ready to increase (i.e. to expand or to extend) substantially its QE program and to reduce its deposit rate which is already in negative territory (-0.20%) at its 3rd December meeting.

In this context, the 2y US Treasury yield increased from 0.72% to 0.93% (+21 bps), the 5y yield increased from 1.52% to 1.64% (+12 bps), the 10y increased from 2.14% to 2.21% (+7 bps) and the famous 30y long bond increased from 2.92% to 2.97% (+5 bps). This bearish flattening pushed down the 5-30y spread from 140 to 133 bps and the 2-30y spread from 220 to 204 bps. On the credit side, the US corporate CDX index widened from 79 to 84 bps due to the first signs of recession in some sectors of US industry and the European iTraxx Main stayed broadly unchanged, from 71 to 70 bps, led by the euphoria preceding the probable increase of the ECB’s QE in December.

The US Treasury yield curve did not move significantly before the 28th October FOMC meeting. But, as the door for a rate hike on 16th December was opened, yields rose sharply and the 2y US Treasury yield increased from 0.63% to 0.72% (+9 bps), the 5y increased from 1.36% to 1.52% (+16 bps), the 10y increased from 2.04% to 2.14% (+10 bps) and the 30y increased from 2.85% to 2.92% (+7 bps). Consequently, the 30-5y spread tightened from 149 to 140 bps. On the credit side, corporate spreads behaved similarly on both sides of the Atlantic: the US corporate CDX index tightened from
94 to 79 bps and the European iTraxx Main tightened from 90 to 71 bps. The greater tightening of the European index, (-19bps vs -15bps) was due to the partial recovery of the European Automotive sector after the September widening at the beginning of the Volkswagen scandal.

In November, following the strategy implemented since June, the Investment Adviser continued to favour high quality and liquidity. Due to the drop in oil prices and the turmoil in Syria/Iraq, he kept reducing exposure to the Middle-East, selling the remaining positions in Qatar (Ras Laffan 2019 and Qatar National bank 2020) and decreasing the weight of Abu Dhabi (by selling Taqa). Consequently, the Middle-Eastern exposure at month end was only 1.1% (consisting of a small remaining position in Mubadala Abu Dhabi). In addition, he sold Volkswagen 2016 (on the same day he took profit on VW 2018 in Strategic European Bond Fund) and reduced the weight of EDC 2018, KFW 2016 and Rentenbank 2016 (now approaching 5% of the portfolio). The proceeds of these sales were reinvested in two European Government agencies short term issues, the Spanish ICO 2016 and the Austrian OKB 2017. Finally, he switched all the 10y US Treasury holdings into a small increase of the 30y position. During this month, the Czech electricity company CEZ made an early redemption of its 4.25% April 2022.

In terms of duration and duration overlay, the Investment Adviser decreased the modified duration of the Fund dramatically in November, from 5.3 to 4. This was achieved by, firstly, reducing the modified duration of the portfolio from 5.3 to 5 and secondly, by reinstating the duration overlay policy as a short position in 2y and 5y note futures (100 contracts each) which was built in order to decrease further the modified duration of the Fund to 4. 

The Investment Adviser believes that the ECB will stay ultraaccommodative and that Mr. Draghi will announce an increase of the ECB’s QE in December. Economic conditions are not significantly 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 ECB’s QE). Regarding the Fed’s policy, the FOMC meeting’s decision on 16th December is clearer: a first rate hike is likely but the perception of the markets is more important. A “dovish tightening” (i.e. a rate hike with no strong conviction) could be well received by the markets. More importantly, the key driver of markets (both bonds and equities) is Forex: the currency war is still in place as many central banks are still in ultradovish
mode, including China and Japan. Consequently, the dollar index (Bloomberg ticker DXY) is more than ever the major factor to follow.

In this context, the Investment Adviser will continue to favour his barbell strategy, favouring a flattening of the 2-30y and 5-30y slopes of the curve. He will continue to be very cautious in corporate bond selection and will focus on high-quality liquid issuers as liquidity is still a worrying issue. Depending on market developments, the Investment Adviser may maintain the duration risk of the Fund around 4 but could increase it, depending on market behaviour after the FOMC decision on 16th December. The Investment Adviser will pursue this strategy (based on lower credit risk offset by above-average yield curve positioning risk with a significant exposure to 30y US Treasuries) during the following weeks and still believes that positive returns will be achievable as a result of the carry of 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 11/12/15 and are based on internal research and modelling.