US: a temporary steepening of the curve ahead of a cautious Fed’s stance


Fund Commentary
26 May 2015


In April, European economies continued to show signs of improvement whilst US economic statistics were mixed and therefore rather disappointing. In the US, unemployment figures were far below the forecasts, adding only 126’000 jobs instead of the expected 245’000, whilst the figure for the previous month was revised from 295’000 to 266’000.

More importantly wage growth, which should be the catalyst for higher inflation in the coming months, remained sluggish. The Federal Reserve (Fed) opened the door to a first rate increase in June but some FOMC members comments show that US policy makers remain divided over whether they would raise interest rates. The Fed’s Mr Williams said “at any time from now” and fellow committee member Mr Evans stayed in favour of raising rates in early 2016. Whatever the date of this initial (or sole) rate increase; the most important point will be the Fed’s stance regarding the pace of the normalisation in its monetary policy. The Investment Adviser believes that the Fed will remain very pragmatic and could postpone its first rate hike until Q4 2015 or early 2016 and would announce that it is not the first of a series of rate hikes. The Investment Adviser remains convinced that as soon as the word “patient” was removed from their statement, US Central bankers have become more patient than ever before! In Europe, the recovery seems to be on track, leading France and Germany to raise their projections for GDP growth. The European Commission increased its growth forecast as well, including Italy which was revised from 1.2% to 1.4%. Despite this good news, unemployment remained very high: increasing in France (with total jobseekers above 3.5 million), in Italy (12.7%) and in Spain (23.7%). The current mood of the market, coupled with substantial improvement in the economy, a rally in equity markets and higher inflation projections has prompted many investors and analysts to bet that the European Central bank (ECB) will cut back its bond purchases before the end of the year. Mr Draghi did not comment but noted that this purchasing programme only started in March. Furthermore, negotiations between Greece and its partners did not progress and could lead to a widening of peripheral spreads in coming weeks despite the ECB’s QE. In Asia, the Bank of Japan (BoJ) remained dovish and the People’s Bank of China (PBoC, the Chinese Central Bank) prepared the markets for another wave of easing due to lower than expected growth in China.

The US treasury curve experienced a bearish steepening, 2y US Treasury yield increasing from 0.56% to 0.57% (+1 bp), the 5y from 1.37% to 1.43% (+6 bps), the 10y from 1.92% to 2.03% (+11 bps) and the 30y from 2.54% to 2.74% (+20 bps). As a consequence, the 5-30y spread (strategy implemented in the Fund at 151 bps) increased from 117 to 131 bps. On the credit side, the US corporate CDX index remained static at 64 bps while the European iTraxx Main widened slightly from 56 to 61.

Assets did not change significantly, from USD 124.3 to 123.6 million. The Investment Adviser sold a small position  in Time Warner Cable after the merger failure with Comcast and fears of a takeover by Charter Communication. The proceeds have been invested in US Treasury 2025. At month end, the Fund held 46 issues and 40 issuers. 

The duration overlay policy was not particularly active in April. Bond trades decreased the modified duration of the portfolio by 0.2 and the short 5y note position was decreased from 200 to 160 contracts, leading to an increase of the modified duration of the hedge by 0.2. 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 and yield war. This first ECB QE is already supporting European economies but not enough to consider a cutback of Mr Draghi’s bazooka. In the US, 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 May 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. As a consequence, positive returns will be achievable as a result of the carry of corporates, their spread tightening potential and credit selection. However, in the coming weeks, the focus will stay on 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 13/05/15 and are based on internal research and modelling.