Market booms and busts and pockets of turbulence and volatility have been around for as long as markets themselves. The persistence in the occurrence of financial market anomalies has been puzzling analysts and academics for years. Some may say many of these market mysteries have been solved, but unexpected and erratic market behaviour is still with us.
German yields spike as Bund re-positioning sparks selloff
Long Bunds was a “crowded” conviction
The German Bund market of recent weeks provides a prime example of erratic market behaviour (see graph). After a relentless rally of more than a year, the market seemed convinced that yields could only fall further as a result of the interaction of quantitative easing (QE), rising deflation risks and the scarcity of government bond supply. Completely opposite to the last year’s consensus thinking that yields were bound to rise, a highly “crowded” conviction came about amongst active market players that they should be long in German Bunds.
Expect the unexpected
The enthusiasm for Bunds had spread to other market pockets, making the US dollar and “bond-proxy” equities such as real estate and utilities unusually popular. While it may be easy to identify in advance where these crowded positions are emerging, it is virtually impossible to know when they will reverse. The risk-return trade-off in Bunds had become so bad that it was difficult to maintain much exposure in that asset class. Even then, however, it was very hard to see what would trigger the sell-off and when it would come. It might seem obvious and easy to understand now, but the main lesson from the recent re-set in the Bund market should be that one-way bets do not exist in markets and that we should always expect the unexpected.
Shake-out in positioning
Rather than looking for fundamental explanations for the bond market reversal, it may be more useful to realize that these turbulent times are driven by a positioning shake-out and that such episodes are inherent to the nature of markets. What may be new are the factors that trigger such incidents. The Bund market seemed to have been sailing in uncharted territory for the last couple of months and the recent correction might even be considered a healthy shock back to a more normal situation, which in turn could create a more fundamentally driven or data-dependent market environment. At the same time, it might be we are still in an adjustment phase and market turbulence might last for another couple of weeks.
Risk-on stance remains in place
We believe that the underlying fundamental story for the global economy remains on its recovery track and will provide an anchor of stability at some point for risky assets. Therefore we see no reason to move away from our risk-on stance in asset allocation. We have adjusted the most interest rate-sensitive parts of our allocation tilts by reducing our government underweight from strong to medium and lowering our overweight in real estate from medium to small.
Within an overall neutral allocation to spread products we scaled back our beta exposure. The overweight EUR high yield (HY) was reduced to small as the category lost momentum amid concerns surrounding Greece and unfavourable market technicals. Still, investor inflows, European earnings and European economic growth are supportive. We increased our allocation to USD investment grade (IG) and mortgage-backed securities (MBS). A widening yield gap versus EUR paper may be increasingly tempting for investors and with a more dovish Federal Open Market Committee (FOMC) meeting in March, concerns of a Fed exit have been pushed out.
Spread performance is reversing
Spread products appear to be in the middle of a performance reversal. Spread markets underwent some setback in the first half of March as market technicals in the Eurozone and Fed exit concerns provoked some spread widening. The weak technicals involved a combination of excess government bond demand in the Eurozone as the ECB initiated its sovereign quantitative easing (QE) program on March 9, while EUR credit supply simultaneously reached a record high. With oil prices tanking by more than 10% in the same timeframe, HY and emerging market debt in hard currency (EMD HC) spreads widened substantially,
Fed meeting was turning point
In hindsight, the March 18 FOMC meeting proved to be a turning point for spread performance. As investor flows returned to the usual suspects in this yield search, namely HY and EMD, spreads renewed a trend of tightening in these higher beta parts. US HY and EMD HC sovereigns in particular outperformed during this period, finding renewed support from a sharp recovery in oil prices, which, interestingly, also started since the March FOMC meeting.
The market technicals that weighed most heavily on EUR credit spreads in March and April remain present. While a position squeeze from “crowded” long-duration Bund trades has tempered the impact of the ECB’s QE program, issuance in EUR IG and HY remains at record highs and may regain traction past the earnings season. Issuers may be tempted to step up volumes to lock in record-low yields, and may perceive the low point in yields as being behind us.
Need to re-allocate triggered Bund reversal
So far, the squeeze in investor positioning appears to be predominantly technical in nature. “Crowded trades” are by definition at risk of reversal at any time, regardless of what triggers the reversal. In the case of Bunds it may have been the absolute record low yield. A very limited upside against a high downside risk may have convinced investors that a re-allocation in portfolios was needed.
This re-allocation is completely compatible with the search for yield and is a very drawn-out process. In its initial stages the very presence of a central bank with unlimited purchasing power sends safe yields even lower and investors ride the wave of portfolio gains. At the start of the next phase, these gains have become so unattractive that the re-allocation of portfolios gets underway, favouring yield plays and sending safe yields higher. We appear to have entered this second stage in the re-allocation process.