The Fed is ready to start normalising its monetary policy…but at which pace


Fund Commentary
23 Jun 2015


In May, US economic statistics recovered with manufacturing activity, leading indicators and employment figures pointing up, while existing home sales fell and the trade deficit widened. The latest Fed minutes confirmed that the US Central Bank expects GDP growth to pick up after a disappointing weak performance in Q1. Moreover, some Fed members’ comments suggest that eventual monetary policy normalisation has been postponed to the end of the year.

In Europe, strengthening economic signs (industrial production, private sector lending and domestic demand) and the European Commission upgrading its 2015 growth forecast from 1.3% to 1.5% have reduced the risk of a serious deflation in the coming months. However, inflation is still short of the ECB’s 2% target and will dampen any idea of the ECB’s Quantitative Easing tapering before its expected maturity (September 2016). During the month, the ECB reached its EUR 60bn QE monthly target and announced that it is preparing to front-load bond purchases in June, to avert lower summer market liquidity. Furthermore, Greece has avoided defaulting but remains under heavy pressure, as negotiations between government representatives and its creditors prove fruitless. The Greek drama has started to push periphery countries spreads wider. In this context, government bond market volatility has also increased given reduced deflation concerns and better growth expectations in Europe but also by the basis of technical factors (thin market liquidity, weak market depth in Futures). 

The US treasury curve experienced a new bearish steepening,  the 2y US Treasury yield increasing from 0.57% to 0.61% (+4 bps), the 5y from 1.43% to 1.49% (+6 bps), the 10y from 2.03% to 2.12% (+9 bps) and the 30y from 2.74% to 2.88% (+14 bps). As a consequence, the 5-30y spread (strategy implemented in the Fund at 151 bps) increased from 131 to 140 bps.  On the credit side, the rising government bond yields had a minimum impact on average credit spreads. Indeed, the US corporate CDX index remained unchanged at 64 bps while the European iTraxx Main widened slightly from 61 to 66.

Assets did not change significantly, from USD 123.6 to 123.3 million. The Investment Adviser kept positions unchanged during the month. At month end, the Fund held 46 issues and 40 issuers. 

The duration overlay policy was stable in May and the short 5y note has been kept unchanged. Consequently the modified duration of the Fund stayed slightly below 5.5.

The Investment Adviser believes that the ECB, which started its own QE in March, will continue to be active in the global currency war and tolerate bond yield volatility until a certain point. This first ECB QE has been well implemented but European economies remain fragile to financial conditions and the QE may run longer than anticipated if needs be 

In the US, the next FOMC meeting should dampen any aggressive rate normalisation anticipation, given increased international macro uncertainties. Current higher treasury yields should be considered as a buying opportunity, 30y above 3% in particular. The Investment Adviser still considers that the US economy is not as robust as thought by the consensus and that the Fed will stay very cautious in an environment where every single piece of bad news could lead to a drop in equity markets. As US economic forecasts are still expected to be contradictory, the Investment Adviser will maintain the duration risk of the Fund above 5 during June and could consider an increase of the duration risk should government bond volatility provide buying opportunities. On the credit side, corporate bond selection will be driven by opportunities in both primary and secondary markets consequently, positive returns will be achievable as a result of the carry of corporates, their spread tightening potential and credit selection. 

The views and statements contained herein are those of Sturdza Private Banking Group in their capacity as Investment Advisers to the Fund as of 15/06/15 and are based on internal research and modelling.