The US bond market is caught between China and the Fed


Fund Commentary
18 Sep 2015


In August, nervousness reached a peak due to uncertainties driven by Greece, commodity prices, emerging markets, and first and foremost China and the Federal Reserve (Fed). Equity markets tumbled after the People’s Bank of China (PBoC) announced a devaluation of the yuan. Consequently, doubts about the pace of Chinese growth arose to a level that could force the Fed to postpone its first rate hike from September to December.

In the US, economic statistics were dominated by the publication of the GDP figures for Q2 (annualised) at +3.7%, revised from +2.3%. The unemployment rate stayed at 5.3% while inflation was still low, with a CPI at +0.1%, PPI at +0.2% and average hourly earnings at +0.2%. The publication of the minutes of the July FOMC showed that the Fed seems likely to raise its interest rate soon but the timing of lift-off is less important than the subsequent pace of increases which would be gradual. The Fed’s monetary policy will most likely remain highly accommodative for quite some time. 

In Europe, mixed French and German data were offset by the Spanish recovery, led by housing and retail sales. The European Central Bank (ECB) announced that it is ready to expand or extend its QE program if needed. Its inflation target is threatened by the drop of commodity prices, the deflationary effects of the Chinese slowdown and the PBoC monetary policy. The Investment Adviser believes that the ECB will stay very accommodative and that Mr Draghi will continue his “whatever it takes” policy. 

In this context, government bond yields have been dominated by flows. Against all odds, during equity markets turbulences, US Treasuries (and Bunds to a lesser extend) did not rally significantly as the PBoC sold huge amounts of bonds. In addition, some emerging market Central banks were also forced to sell Treasuries as they needed US dollars to stop the collapse of their currencies. As a consequence, the 2y US Treasury yield climbed from 0.66% to 0.74% (+8 bps), the 5y yield from 1.53% to 1.55% (+2 bps), the 10y from 2.18% to 2.22% (+4 bps) and the 30y from 2.91% to 2.96% (+5 bps). Consequently, the spread 30-5y rose from 138 to 141 bps. On the credit side, corporate spreads behaved similarly on both sides of the Atlantic: the US corporate CDX index widened from 71 to 82 bps and the European iTraxx Main from 62 to 71 bps. More importantly, liquidity decreased sharply in the low quality universe (BBB, crossover, high yield, subordinated debt and hybrid bonds) and this was not due to the fact that traditionally, in August, volumes are low.

In August, following the strategy implemented in June and July, the Investment Adviser focussed on liquidity, issuer quality and the correlation between the behaviour of the stock markets and the Fund (through its investments in corporate spreads) in order to align (more than in the past) the Strategic Global Bond Fund as a natural hedge against US equities.

i)    Higher liquidity: purchase of US Treasuries, European government agencies and government-owned corporates, increase of high-quality corporate issuers. The Investment Adviser bought BNG 2016, General Electric 2017, Cisco 2017, Daimler 2017, Linde 2018, Toronto Dominion 2018, Microsoft 2018, Enel 2019, Oracle 2019, Merck 2019, Procter & Gamble 2019 and increased expsoure to US Treasury 2045. 
ii)    Higher credit quality / lower correlation to stock markets: huge decrease of BBB issuers, sale of BB, sharp decrease of oil & gas and cyclicals (autos). The Investment Adviser sold Pernod-Ricard, America Mòvil, General Motors, Ford and Autozone, whilst reducing expsoure to Grupo Bimbo.
iii)    Lower exposure to Asia: sale of KDB, Korean Resources Corp, Export-Import bank of Korea, Cnooc, Sinopec and China Uranium Development in order to decrease the weight of Korea to 1% and China to 0%.

The Modified Duration of the Fund has been held above 5.6 and the exposure to the long end of the curve (30 years) has been increased to above 12% of the portfolio but above 40% of the duration risk. At the same time, the duration overlay policy has been removed. At month end, the Fund held 44 issues from 38 different issuers.  

The Investment Adviser believes that the Fed will stay very accommodative and that Ms Yellen will continue to provide guidance as to the future behaviour of the Fed as she has in the recent past: the first rate hike will occur before year end, but the pace of rate hikes will be very slow and the US Central bank will remain ultra-accommodative. In this context, the Investment Adviser will continue to favour a flattening of the 5-30y slope of the curve with a target of 100 bps (141 bps at month end) and will continue to be very cautious in terms of corporate bond selection, focusing on high-quality liquid issuers as liquidity is becoming a worrying issue. Depending on the development of the market, the Investment Adviser may maintain the duration risk of the Fund between 5 and 6. 

The Investment Adviser will continue to pursue this strategy (based on lower credit risk offset by above-average duration risk) during the coming weeks and still believe that positive returns will be achievable as a result of the carry of PSPP 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 15/09/15 and are based on internal research and modelling.