By Basil Williams
For the first time in many years, we are entering
an environment where the four major central banks will not be
acting in concert as they each seek to manage their respective
economies for growth. Some are battling deflation and others
are hopeful for modest levels of inflation. As a result, we
will start to see rate divergence between the major markets
breaking long held linkages that consistent central bank
policies have provided. This is likely to be associated with
higher levels of interest rate, yield curve and cross market
volatility, creating risks for buy and hold fixed income
portfolios and money making opportunities for active traders
who can be both long and short markets.
The genesis of this divergence stems from the
relative degrees of success that the leading world economies
have had in shaking off the effects of the global financial
crisis. Our view is that the U.S. and U.K. are on the road to
recovery and will be leading the global economy forward, while
the two other major central banking systems, Europe and Japan,
are still struggling to gain enough economic growth to
accelerate themselves forward.
As a result, markets are debating the timing and
trajectory whereby the Bank of England and the Federal Reserve
will begin to raise rates in the near future. In comparison,
the European Central Bank and the Bank of Japan are continuing
their easy monetary policies. The economic backdrop for
divergent policy responses continues to evolve. In fact, the
ECB's recent round of rates cuts and new policy initiatives are
their first action in many months despite the worsening
Away from the Eurozone, we believe the market is
now going to focus on three factors:
1. What is the timing of the first rate increases
in the U.S. and the U.K.?
2. Once begun, how rapidly will rates rise in each
of those markets?
3. What will be the respective terminal short term
This last question is one that has only just
started to emerge in the past 60 days. Historically we have been accustomed to rates
cycles topping out in the 4-6% range but there is quite a bit
of speculation that this rate cycle is different. Many
prominent bond market investors and economists, including
ex-Fed Chairman Bernanke, have speculated that this time we may
only see policy rates approaching 2-3%.
There is a healthy counter debate that given the
amount of stimulus that has been injected into the market place
and some of the potential for inflation coming from the lower
short-term unemployment rate (as opposed to the overall rate),
the expected increase in health care costs, and the tight
supply of rental properties, that the rate cycle will be more
normal. In either case the world is shifting to one that is
much more data dependent and thus a more difficult environment
in which to manage fixed income portfolios.
In terms of investing, these factors make for what
could be a headache inducing time for fixed income portfolio
managers, making it more difficult for long-only fixed income
traders to extract much in the way of return. We have 10-year
yields in the U.S. and U.K. in the mid-2% range and 30-year
yields around 3.5% - not exactly heroic levels of yield.
Additionally, as a result of the various reaction
functions of the central banks around the world, people are
going to focus more keenly on each and every economic data
release, and that will likely translate into price movements as
data is either in line with expectations or, as is more
frequently the case, out of line with expectations, creating
trading opportunities within the markets.
We think that large institutional investors and
pension funds should reevaluate their long-only portfolio
allocations. Many assets that have intermediate maturity -
yielding in the 1.5-3.5% range - are unlikely to meet the
return bogeys of the pension fund itself, and given the low
level of yields, are also unlikely to provide the price
appreciation diversification that one would want to balance the
portfolio in times of poor equity market performance.
We are starting to see the more sophisticated
investors consider allocating a portion of what heretofore had
been their long-only fixed income portfolios to include more
non-traditional approaches to investing in fixed income.
Our call is thus for a trading oriented market in
which the trading of hedged relative value positions in
sovereign debt, investment grade corporates, municipal bonds
and agency mortgages will be filled with opportunity
independent of the direction of rate changes. Underscoring this
opportunity will be the market dislocations created by
long-only investors adjusting their portfolios in response to
unexpected economic outcomes and/or policy responses. These
dislocations are also likely to be greater than in prior cycles
given the reduction in market making capital at the major
investment bank trading counterparties.
In short, all of these factors will combine to
produce an environment more beneficial to astute trading
ability than passive investment.
Basil Williams is co-CIO of Mariner
Investment Group, the global alternative asset