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Fixed Income Letter - More complexity more opportunities

EDITORIAL

Global financial markets were quite friendly despite significant political uncertainties in 2016. Not only were the markets caught completely wrong-footed by Brexit referendum and US election. Against all expectations, political risk ended up being a positive factor in 2016, with equity market performance exceeding all hopes.

In 2017, things could be different. Looking beyond the positive impact of the measures planned by the new US administration, the first backlash could be felt, and Brexit’s negative outcome could materialize during the year.

Political risk is also back in Continental Europe, with elections coming up in the Netherlands, Germany, France, and, perhaps in Italy. In France, four candidates are running neck-in-neck, two of which are known - to say the least for their wariness of the financial markets. The uncertainty surrounding the first round of the presidential election is starting to give investors food for thought. In spite of the ECB’s ongoing purchase programme, the spread between France and Germany has widened, and so did - in sympathy - peripheral premiums.

What’s the best course of action? First of all, let’s recall some points that may be obvious but are still useful to remember:

  • Diversify portfolio positions while refraining from any knee-jerk reactions (in other words: don’t rush into bonds just because spreads have widen by a few bps); and 
  • Remain open to take profit from what’s happening elsewhere in the world, whether in emerging markets or in the US.

So should European bonds only be bought out of pride? That would be too hasty of a conclusion. Some sectors would fare well even if interest rates rose. Here are our recommendations at start of the year: inflation-linked bonds and high beta assets, such as high yield or hybrid bonds. Similarly, the inevitable, election-driven volatility will also be good news for actively managed portfolios by offering arbitrage and other opportunities during the year. 

To conclude, just a little reminder for those who may have forgotten: negotiations among Europeans always start out with lots of teeth-gnashing, shouting, insults and threats, but they do end up getting together and finding solutions (that may not be permanent solutions, but they’re still solutions). At the end of this year, the current ruckus could well look pointless, along with France-Germany spread, which may well return to its recent years’ average.

Marie-Anne Allier Head of Euro Fixed Income

CONVICTIONS

Rates at their low levels and duration risk at its highest levels 

Bond markets are currently facing tailwinds risks and are being pushed into opposite directions.

At a time of very low interest rates and high duration risk, flexibility is key in managing Fixed Income portfolios.  Fears of higher interest rates have pushed some investors to favor, tactically, low duration solutions. Others investors, did allocate in favor of Absolute Return strategies.

An absolute return approach makes perfect sense in this environment and offers investors performance that is de-correlated from market beta (duration).  

Our Absolute Return strategy offers investment solutions over a wide range of bond and currency market configurations. Our dual approach is based on:

  • either a single asset class (credit or forex),
  • or an allocation strategy aiming to get the most out of the bond and currency markets.  

Flexibility makes it possible to switch from one asset class to another through both long and short positions, based on a global macro approach. It also allows us to mix investment horizons between strategic and tactical positions, thus de-correlating the fund’s positions. Alpha is generated thanks to our capacity to optimize funding as well as our ability to implement relative value trades.

The success of these strategies also requires a suitable risk approach in order to deliver more steady performances and, ultimately, a better Sharpe ratio. Indeed, within Amundi, absolute return does not come at the expense of portfolios’ liquidity. Our absolute Return approach relies on Performance, Risk, Liquidity pillars.

Laurent Crosnier CIO Amundi London

Property investors mantra has always been “location, location, location”

In the coming years, global investors will see a return to an equivalent mantra - “dispersion, dispersion, dispersion”.

In the years following the 2008 global financial crisis, markets have experienced for significant periods of time a phenomenon known as RORO (Risk on/Risk Off) where the benefits of diversification were much lower than usual. What that meant was markets became highly correlated with each other and driven by a common factor - typically risk sentiment. Assets became either “risky” or “risk-free”.

The implications were that multi-asset portfolios could be much less diversified than thought and at times of sentiment shocks, correlations would move close to one thus sharply raising the portfolio risk for any given position. As we move away from a pure RORO paradigm, local idiosyncratic factors are starting to take back their own importance and increasingly drive asset performance resulting in a large divergence in the risk/return profile of assets.

Being right in the direction of an asset class (beta) will no longer be sufficient to outperform. The precision in the selection of assets within an asset class will be crucial to performance. 2016 provided a very clear example of this. Within EM FX, BRL and RUB returned +38% and +33% respectively while TRY and MXN depreciated -8.6% and -13% respectively. Being long EM FX was not enough. Being long/short the right FX pair mattered much more.

This shift back to local factors will continue this year and the years ahead as policymakers try to unwind the extreme monetary policies & large central bank balance sheets at the same time governments boost fiscal policies. Successfully identifying those divergences within each asset class will be key to outperforming.

Philip Chow CIO Amundi Singapour

Bank of Japan: perception is believing

Since last November, it has been widely commented among the JGB market participants that BOJ has had one objective: to contain the longer end of the JGB curve within a narrow range defined with the ceiling at 0.65% for 20year and 0.80% for 30 year, on top of the clearly indicated level of 10 year at around 0%. However, the recent actions taken by BOJ to react to improvement in the economic outlook have confused bond investors about the level where BOJ wants to maintain the yield curve. Despite one of the BOJ’s intention to have introduced YCC (“yield curve control”) as to potentially reduce the volatility of the market, the latter being gradually increasing due to BOJ’s complicated signals to the market.

It is becoming less promising to take flattening positions based on the expectation to sustainability of YCC. Instead, capturing the distortion of the shape of the yield curve cushion without taking duration risk seems to work better.

  • Relative value positioning based on yield cushion analysis: long 2, 7, 10, 20 year at the cost of deep short position in 5 and 30 year.
  • BEI position will work well supported by increase in inflation expectation.

 

USA - Of bank balance sheets, public and private

The January effect dominated the political transition effect last month. Though markets priced only slightly better growth prospects, spreads on all manner of fixed income credit instruments tightened yet again and have moved further into overvalued territory in light of tectonic shifts emanating from Washington D.C. The implied volatility in credit spreads is very low, yet uncertainty is high. Will the newly elected representatives deliver the low volatility, optimistic scenario priced by the market? Better to hold some cash in reserve until we find out.

The “balance sheet” that has been on many people’s minds lately is that of the Federal Reserve Bank. The Fed holds $4.2 trillion of Treasury and MBS securities acquired through Quantitative Easing programs and subsequent reinvestment. Anxiety in the marketplace is growing that we may be approaching a moment that will rival the shock value of the Taper Tantrum of 2013.

Our view is more sanguine: The Fed’s balance sheet is simply a tool of monetary policy that is a companion to the traditional short-term rate mechanism. The Fed uses its tools considering the overall framework of “financial conditions,” or an assessment of the cost and availability of capital in the financial system. Markers include not just short-term rates but equity prices, intermediate rates, corporate bond spreads and the relative value of the U.S. dollar. The level of the Federal Funds rate and the size of the balance sheet affect financial conditions in different ways. Clearly, the balance sheet tool would have a more significant impact on intermediate and long-term interest rates, given the maturities of the securities owned by the Fed. Less obviously, the balance sheet tool and short-term rates affect the value of the U.S. dollar in different ways. The Fed will cautiously “taper” reinvestment once the Federal Funds rate exceeds 1% (perhaps higher) with an eye to the impact on financial conditions. The more the market reacts to cautious balance sheet reduction, the slower will be the pace of future rate hikes.

Though the Fed’s balance sheet is front and center in the market’s attention, there are intriguing developments in the private sector which bear watching. We have written extensively about bank deleveraging and its major impact on low-risk activities including repo lending and market making in fixed income and foreign exchange. 

2017.02 - FI letter - Balance sheet shortage ebbing

The squeeze in bank balance sheets was reflected in extraordinary narrowing in interest rate swap spreads and cross-currency basis swaps. We note with great interest that the narrowing in these spreads has reversed lately and seems to be picking up some momentum as the pendulum on bank regulation, at least in the United States, seems to be reversing direction from its post Financial Crisis apex. Will de-regulation reverse the “de-leverage dividend?” We will be watching.

Dan Dektar CIO Amundi Smith Breeden

Source : Amundi. Past performance is not a reliable indicator of future results or a guarantee of future returns.

Eric BRARD, Global Head of Fixed Income at Amundi
Laurent CROSNIER, CEO & CIO at Amundi London
Marie-Anne ALLIER, Head of Euro Aggregate at Amundi
Shinichiro ARIE, Head of Japanese FI at Amundi Japan
Patrick GUIVARCH, Head of Insurance Solutions at Amundi
Daniel C. DEKTAR, Chief Investment Officer, Amundi Smith Breeden
Dan ADLER, Amundi Smith Breeden
Philip CHOW, Fixed Income CIO, Amundi Singapore

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Fixed Income Letter - More complexity more opportunities
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