Bond market performance weakened following Fed comments on tapering QE.
Over the next couple of quarters, we expect a transition from a market priced for liquidity to one priced for growth.
We believe markets will eventually begin to focus less on the Fed and more on the fundamentals of a slowly improving global growth story.
Global bond markets have been under siege for much of the past two months. Looking back to April, the bond market, in our assessment, was expecting “quantitative easing (QE) forever.” Bernanke reminded us after the June FOMC meeting that we may only have “QE for now.” Since those comments, markets have been marking QE to market by pushing yields and risk premiums more broadly higher. This is a significant development for monetary policy as it seems that the era of new monetary easing is over. We believe this confirms our thesis of a monetary policy inflection point in the first half of 2013, in which the Fed begins to provide the roadmap for its eventual exit from unprecedented stimulus. The market reaction has been quick and violent, but we believe this change of course by the Fed is now largely priced in.
We believe the most likely next step may also be the one the market is not expecting: Growth. In the U.S., we must remember that the Fed is talking about tapering QE because they believe the economy can handle it. Indeed, we agree that there are encouraging signs in both the U.S. housing and labor markets. And while the private sector economy looks good, the largest components of fiscal drag (tax increases, sequestration, etc.) are now behind us, increasing the likelihood of upside growth surprises in the second half of the year. In addition, there are some encouraging signs of growth throughout the developed world. This includes Japan in which we expect large scale monetary and fiscal stimulus to bring growth, if only temporarily, well above trend. In addition, there are some more recent signs of stabilization in the eurozone as well. While the market has recently been focusing on what it is likely to get less of (liquidity from the Fed), we expect the second half of the year to be more about what it is likely to get more of (developed market growth).
- In the bond market, we expect Treasury yields to end the year only modestly higher than they are today, with price action more dependent upon changes in economic data than upon QE.
- Inflation protected securities (TIPS) have taken more than their fair share of the selling recently. With TIPS pricing in less than 2% inflation per year over the next 10 years, we believe an investment in TIPS looks much more compelling today.
- Emerging market bonds have also lagged this year. However, we think the recent volatility has created some value. While growth differs widely between regions and countries, we believe EM will be a beneficiary of improving global growth and feel there are attractive opportunities now in EM debt.
- Early in the year, we recommended high yield investors consider the bank loan market for an attractive yield with less risk. As bank loans have outperformed, we now believe the outlook for the two markets is more balanced.
In the second half of the year, we believe markets will begin to focus less on the Fed and more on the fundamentals of a slowly improving global growth story. This should provide more attractive prospective returns for bond investors. But the transition from liquidity to growth may not be as smooth as we’d like.