As January drew to a close on a slightly more orderly note, we look back at performance across the sectors in fixed income.The surprise performer with a day left in the month turned out to be US Treasuries (UST) and other highly correlated ‘risk off’ rates products. The 10 year UST began the year at just over 3 per cent yield and now trades at 2.68 per cent, a move of exactly 3 per cent. Gilts have followed suit, putting on nearly 2.5 per cent on the month. Like most forecasters, gilts were our least favoured sector pick for 2014 as we are concerned about the mark to market risks as the economy progresses and as we move very slowly towards a normalisation of monetary policy. The rationale for being bearish is a strong one and one that we will not deviate from, unless the underlying fundamentals change.
However, the rationale for the rally in January is also a strong one, especially as far as Treasuries are concerned. Emerging market (EM) weakness appeared in many pockets during the month with Argentina, Turkey and South Africa taking the brunt of the moves, and rightly so as each has their own fundamental weakness. This has impacted their currency valuation and has forced policy responses in those markets. Contagion, both fundamental and technical, has spread to include the likes of Russia and Brazil.
Importantly there is enough noise to make all markets sit up and listen
The hard currency for EM is the US dollar and consequently these nations all have a fair amount of USD denominated debt; debt that was perceived as a safe haven during the eurozone crisis and debt that was deemed attractive while the Fed was squeezing the value out of many parts of the market. The hedge for dealers trading in USD denominated EM is US Treasuries. So as EM is sold the risk off is back to UST.
So where does that leave us going forward?
All the time that the EM problem remains an ‘EM problem’, the technical demand for USTs will remain and could push yields lower. Provided it remains confined to EM though, we see this as another opportunity to hedge interest rate risk more cheaply.
However, a prolonged period of EM weakness will ultimately affect the broader fundamentals and this may delay the economic progress in the developed world and push policy normalisation down the line. This is not our base case but we must be aware of this risk. We should also bear in mind that central banks have been in a proactive mood in recent years and remain willing to act, and we think ultimately if contagion spreads to those more healthy EM economies, some sort of intervention is likely. However in the short term it is unwise to rely on this as markets are typically left until the pain is widespread before intervention tends to be effective. We think therefore the Indian Central Banker, Raghuram Rajan, may have been premature in his recent cry for help.
It is interesting to note that since this was written the strength of gilts has had a knock on impact for pension schemes
Back in January the latest PPF 7800 Index showed a huge improvement in funding levels to 97.6 per cent (a deficit of £27.6 billion). By the end of January this had shot down to 93.7 per cent, an increase in this measure of the combined deficit of nearly £50 billion. This was almost entirely down to the increase in the measure of pension scheme liabilities used by the PPF.
Alistair Wilson is head of institutional business at TwentyFour Asset Management