What to expect from the upcoming central bank rate policy divergence

Mon Jun 16, 2014

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Increased volatility means increased opportunity.

  Basil Williams of Mariner Investment Group 

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 deflation risk.

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 rates?

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 manager.

ISSN: 2151-1845 / CDC10004H

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