- “During the past decade, any bouts of volatility were short lived, because central bankers were coming to the rescue”
- “We are at the beginning of a new cycle, in which the Federal Reserve is stepping away, taking down its balance sheet, the European Central Bank has reduced their monthly purchases, and even the Bank of Japan is slowing down its quantitative easing program”
- “In the US, the necessity of financing a swelling deficit has significantly increased the supply in Treasuries”
Borrowing Donald Trump’s electoral campaign slogan, Dan Siluk, co-manager of the Absolute Return Income strategy at Janus Henderson, explained at the Madrid Knowledge Exchange 2018 event that markets are at the beginning of a new cycle of quantitative tightening that will “make rates great again”.
In the past decade, the intervention of the three main central banks were able to save the global economy from the financial crisis, but at the same time there were some intended and unintended consequences. The balance sheets of the Federal Reserve, the European Central Bank and the Bank of Japan rose exponentially, substantially dampening the volatility in the markets.
The VIX index, who typically settled in the 20 – 30 points range over decades, in the last ten years traded in a very tight range, between 10 and 15 points. Any time there was a bout in volatility, the presidents of the central banks always came back to give an answer that reassured the markets. That’s what happened during the Greece and the Eurozone crisis in 2011-2012, when Mario Draghi pronounced his “Whatever it takes” speech, or in the “taper tantrum” episode, in the summer of 2013, when Ben Bernanke’ FOMC statement was interpreted by bond investors as a sell signal.
With a clear correlation between central banks’ balance sheet size and the value of global assets indices, there has been inflation in practically all the asset classes, something that has greatly favored passive investments, like ETFs and index funds.
“In the past decade, investors could do pretty well by simply earning the beta of the market. They could obtain an attractive performance regardless whether they owned rates or credits, just because rates were driven lower, and credit spreads were driven tighter. Any bouts of volatility were short lived, because central bankers were coming to the rescue. So as long as investors could ride through those periods of volatility their fixed income portfolios tended to do pretty well”, said Siluk.
However, consumer price inflation has barely appeared. Except for United States and United Kingdom, were inflation expectations are lower in the near future, is expected that there will be a real inflation growth in the rest of developed economies, that would be the case of the Eurozone and Japan. In the latter country, after decades of low growth, consumption and growth in wages is returning. While in the Eurozone, unemployment levels are declining in many of the member states. Also, the Asian region excluding Japan is contributing significantly to global inflation. The emerging consumer is one of the fastest growing segments of the global economy and lately is leading inflation.
According to Janus Henderson Investors’ portfolio manager, we are facing the beginning of a new cycle, in which the Federal Reserve is reducing its balance, the European Central Bank has reduced the volume of monthly of its program purchases, aiming to finalize it at the end of year. And, even the Bank of Japan, in the last two years has slowed its program of quantitative easing, sporadically decreasing its balance.
Upside risks to rates
In the US, the necessity of financing a swelling deficit has significantly increased the supply in Treasuries. This increase together with a decrease in foreign investors demand on Treasuries, mainly due to the higher cost of hedging the exposure to US dollars, has partially diminished the total demand for Treasuries.
“Fiscal expansions tend to generate high levels of inflation. Even when there is a strong dollar due to the diversion in monetary policies among developed economies. Trump’s administration has certainly a bias towards a weaker dollar, which is inflationary. All these factors support our vision that rates are going to climb, and curves are going to steepen, that does not necessarily mean that we are going to wake up one morning and see rates 25 or 50 basic points higher. Typically, what happens is that they try to trade in a range and when they break that range, the highest point of the range becomes the new support level. For quite few months of this year, we have seen these 2,70% -3,0% yield range in the US Treasury 10-year bond. We just broke the 3,0%, and at some point, this 3% becomes now the point that backs up a resistance level”, he said.
All these factors are pointing out that you need to be very nimble in fixed income management, specially in terms of asset allocation. Therefore, in this strategy, they favor a benchmark agnostic strategy.
“Benchmark indices normally have certain limitations. We need to be active and flexible, to invest anywhere around the globe. For example, today, rather than bear interest risk in US, which is rising rates, we are looking at commodity-producing countries, like Australia and New Zealand. Because China is slowing down, these economies have very high household debt to income ratios. Their banking costs are increasing. Local banks are rising mortgage rates, whereas central banks are on hold. So, the domestic banks are partially doing the job of the central banks, who are maintaining a dovish position. We rather have interest rate risk in countries that are dovish or on hold monetary policy”, he explained.
“We will probably look back to US Treasuries when the Fed announces they have reached their neutral point. The US is today the highest yield across the developed world. It is also a very steep curve in the front part of the curve. The 10-year Treasury bond yields are offering a spread of 20 basis points over the 2-year notes, so investors are not actually getting paid for the additional interest rate risk or duration risk. On the other hand, the front-end of the curve will be an even more attractive investment once the Fed will finish their hiking cycle”, he concluded.
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