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Is the Fed about to make a policy error by raising rates too soon? The whole of this year financial markets are obsessed with the question whether the Fed will start normalizing short-term rates. Fed policy makers have fueled the discussion themselves by speaking out intentions to do so.
It has been seven years ago since the Federal Funds Target Rate was brought down to 0% - 0.25%. This was followed by several quantitative easing programs.True, seven years after the start of the Great Recession the US economy is in much better shape. However, downside risks are looming. Global demand is weakening due to the China slowdown. The US manufacturing sector is suffering from a strong US dollar in combination with a drop in global trade.
Deflationary forces are gathering pace again. While there still is hardly any evidence of any significant domestic wage pressure, global developments are even pushing down inflation (expectations) in the US and elsewhere. The Fed’s five year breakeven rate reached a decade low early October. The spectacular decline in commodity prices in recent years is eye catching. Global excess capacity looks ample.
In the past we have had many examples of central banks raising rates too soon. It is what happened several times in Japan over the past quarter century. In 2000 the Bank of Japan misjudged a small pick-up in inflation as a sign deflationary pressures were overcome. A year later the central bank was forced to cut rates back to zero. History repeated itself in 2008 when the BoJ was forced to bring back official rates close to zero again having raised them in the two years before.
Closer to home and of more recent date is the European Central Bank hiking rates in 2011 on fears that higher energy prices would have a lasting impact on long-term inflation expectations. Within six months Mr Trichet had to cut rates again as the euro area economy entered another recession. The Swedish Riksbank’s decision to start normalizing rates in 2010, has also become a classic example of a policy error. Paul Krugman described the policy as ‘sadomonetarist’. After bringing back official target rates back to 2%, deflationary threats drove the central bank to change course drastically within the year. Official target rates were lowered to zero, later to be followed by quantitative easing.
So while its sounds reasonable to start normalizing, Fed officials face a very delicate decision in the light of the uncertain global economic backdrop. Our best guess is that they stay on hold for the remainder of the year thereby increasing pressure on the BoJ and the ECB to step up their respective stimulative programs. Does not sound bond-unfriendly to us.
In recent months we increased the overall duration of our Rorento global total return bond fund to roughly six years. Weaker economic data have lowered the likelihood of a Fed rate hike later this year. In a low growth, low inflation world US Treasuries are our favorite pick. The yield spread versus European bonds is wide in a historical context. It is the classic safe haven asset in case financial markets would come under further pressure.
Spanish elections have resulted in underperformance of Spanish government bonds versus their Italian counterparts. We believe this will revert. Growth dynamics are superior: 3% growth versus sub 1% growth for Italy. Debt to GDP is 30% lower for Spain. The rating outlook compares favorably. S&P raised the outlook for Spain to BBB+. The Spanish debt agency has frontloaded, meaning less issuance pressure in the fourth quarter than in Italy.
The credit environment turned more hostile over the third quarter. Year-to-date excess returns moved into the red for all credit subcategories. Even our favorite segment, subordinate financials, came under pressure. In our portfolios we reduced our overall exposure to credits whilst maintaining a clear preference for subordinate financials. Financials will regain the ‘safe haven’ status that it used to have within the credit spectrum before the banking crisis and the Great Recession that followed. Once comfortable with a particular issuer, there is value in going down the capital curve.