Bond markets - Few places to hide
Asia - Panic sellers ignore fundamentals
Russia - Local causes of a vicious correction
Fund managers - Investors turn defensive
Equity market - Earnings might outstrip rate rises
Latin America - A region immune to volatility
Bond markets
Few places to hide
Graham Neilson, ABN Amro's global head of credit strategy, is emphatic. "This isn't 1997 again, and it isn't 2001 again. It is 1993/94, and the comparison is not lost on the market," he says. "The comment then was that rates going up presented an opportunity to buy. That was bollocks the first time around and it will be again."
The upshot of interest rate rises in 1994, as Neilson points out, was one of the biggest bond market unwinds ever. "Bond yields went from 5% to 9% and people were carried out," he says. "It challenged the assumption that you should be a buyer in a dip."
So asset allocators that have learnt their lesson will be allocating less capital to fixed income, and are keen to take profits.
"We've seen profit-taking from Asia, especially the Asian central banks, including in euros," says Dimitri Toseland, principal in the European high-grade fixed-income unit at Banc of America Securities. "Big sell orders came in in the second week of May."
This is bad news for investment banks. "The current quarter will be dramatically worse for bond trading profits," says Toseland. "Liquidity dries up, and people stop picking up the phone."
If institutional investors are selling, retail investors might yet fill part of the gap for issuers. "There were two 10-year Eurobond deals the same week from Austria and the EIB, both with 5% coupons," says Toseland. "That's psychologically important. Retail is buying bonds again because it sees them as attractive, especially Swiss retail, which has been quiet."
For the fixed-income markets, the big question is, what will happen in the second half of 2004 and in 2005? The market seems to be relying on rising interest rates being incremental and already priced in.
But second-guessing the Federal Reserve is a risky business. "The Fed needs to normalize monetary policy now that the slack in the economy is being rapidly absorbed. The issue is, what constitutes normal?" says John Higgins, chief economist and head of research at Nomura International's fixed-income division. "The market expects that the Fed will embark on a tightening cycle at the end of June. But what is it going back to? There is an assumption in the marketplace that the Federal funds rate will be at or below 4% by the end of next year, which would still be less than many people's estimate of neutral."
The big unknowns include whether the Fed has failed to understand the strength of the US economy during all the agonizing over the so-called jobless recovery early this year and how it will respond to market panics.
"If stock markets are falling, a rate hike by the Fed is not a given," says Ciaran O'Hagan, head of liquid markets, fixed income and European strategy at Lehman Brothers.
"The Fed is clearly more dovish than the majority of market participants," Andrew Roberts, Merrill Lynch's chief European fixed-income strategist, argued at the Bond Market Association's Global Government Bond Congress last month. "It is very worried despite strong US GDP growth. US consumer debt is rising, equities are down 2.5% year to date, and there's no pent-up demand. A Fed hike is not a done deal."
Europe is even harder to call. According to the European Central Bank's monthly bulletin in May, most estimates for the current natural real interest rate in the eurozone are between 2% and 3%. The ECB cautiously suggests that there are good structural reasons for them to stay low. And the market could be making a mistake in pricing for an ECB rate rise. The Fed's move towards a neutral interest rate stance doesn't dictate a rate rise from the ECB, because the ECB is already neutral.
However, the fact is that European markets react to US stimuli.
"The US and euro markets track each other very closely," says O'Hagan. "Since mid-April, for a 24 basis point rise in TIPS 14, we have had just a 9bp rise in BTPei 14, so the leverage is greater in dollars. But the closeness of the correlation illustrates that local demand in the US or Europe is not the main driver behind prices. Rather, the reasons are mostly macroeconomic, like overly low Fed rates. This should continue."
Other factors will affect investment decisions. Alongside monetary policy, pension reform in Europe is contributing to the flattening of the 10 to 30 year curve. And the decline of the dollar hasn't yet corrected the US balance-of-trade deficit. The 10-year dollar bear market of 1985 to 1995 only ended with clear signs of a balanced US budget.
And anyway, according to Fred Cleary, director, global inflation linked strategy at UBS securities, US inflation is driven by domestic factors, and is not a result of the weakened dollar. "This creates an interesting scenario, where short-term interest rates and growth outlook could become dislocated."
Assuming Europe and the US are entering a rising rate environment, with both share and bond prices falling, is there anywhere for fixed-income investors to hide?
Inflation-linked bonds have been popular with issuers and investors in Europe. It's not clear whether they will remain so. According to UBS's Cleary, inflation-linked bonds have lost much of their defensive quality. "We've seen a four-year bull market in real-return products," says Cleary. "Inflation-linked bonds have corrected the ridiculous prices of last summer. Now you can observe very low levels of real yield."
Others think that inflation-linked products are still worth buying. "There's too much inflation-linked premium priced into the market at the moment," says Lehman Brothers' O'Hagan. "Let's not forget the reasons that are keeping real rates at low levels, and will continue to do so. These are far better reasons to buy OATei or BTPei as a long-term holding."
Emerging markets are a big risk. "There are a number of structural concerns regarding the sensitivities of emerging markets to the cycle," says Brian Lawson, chief operating officer, fixed-income division, at Nomura in London. "First, emerging markets have had an exceptionally strong correlation with each other. Secondly, a lot of hedge funds have been momentum buyers worried about missing out on any rally. That makes them exceedingly rapid potential sellers in a rising rate environment. And thirdly, we're due a major shock sooner or later. Based on average cycle length, that could be in about six months."