By Thomas Marthaler
With the summer fast approaching, amusement park attendance is sure to rise. But investors need only look at the financial markets to experience their fair share of thrills and chills.
Case in point—the recent roller coaster ride in the global government bond market. When June began, the yield on the U.S. 10-year Treasury was 2.12%. By the 10th of the month it had risen to 2.50%, only to ease back to 2.32% on June 17, the day the Federal Reserve concluded its latest meeting. Higher rates weren’t limited to the U.S., spiking in Europe and Japan before recouping some of their losses.
What’s driving this ride? To some extent, it’s due to shifting expectations regarding the global economy and the market overreacting to incoming data points. Looking back, growth in the U.S. and many other developed countries was weak to start the year, leading to a rally in many government bond markets. Adding fuel to the rally was the European Central Bank’s quantitative easing program. This technical imbalance pushed the German bund yield into negative territory on some parts of the curve. Add in periodic flights to quality due to geopolitical issues—such as the debt crisis in Greece—and you had recipe for falling yields. More recently, economic data in the U.S., Europe and Japan have often surprised on the upside. We believe the market realized it had gotten ahead of itself and rates quickly sold off—only to edge back when they moved too high.
We view the recent re-pricing of yields to be more consistent with underlying global economic trends. At the same time, deflation fears have diminished and global developed market interest rates are now pricing in a more realistic inflation premium. Overall, the interest rate markets are starting to move in line with our expectations, as our fair value estimate for the 10-year Treasury has been between 2.75% and 2.95% since last year. What’s more, the Fed’s median estimate for the Fed Funds rate has shifted down and is now 1.625% for the end of 2016, versus 1.875% in March. This is more closely aligned with our expectations and those of the broader marketplace.
Historically, periods of abruptly rising rates tend to be short-lived, and thus far, history seems to be repeating itself. That’s not to say that we’re out of the woods in terms of market volatility. Global growth and inflation expectations that surprise on the upside or downside are likely to set the volatility ride in motion once again, as could missteps by global central banks. And the situation in Greece remains fluid and could potentially have global ramifications, although we think cooler heads are ultimately likely to prevail.
While market gyrations can be unsettling, we view them as opportunities for fixed income investors to capitalize on temporary mispricings. In the U.S., market gyrations may mean underweighting or shorting Treasuries while, at other times, being overweight or long Treasuries. It could also be prudent to strategically adjust allocations among the various spread sectors. In Europe, it may be wise to employ relative value trades by being underweight or short core Europe versus peripheral Europe. At other times, overweighting the core may be beneficial. Looking at the credit market, fundamentals remain positive and current spreads are generally in line with our expectations. This too could create the ability to generate incremental yield.
In conclusion, we believe the summer months may be far from relaxing for investors. But periods of market volatility need not always be feared, as they often breed a steady stream of investment opportunities. What’s more, we believe rate fears are being overblown, as we expect them to edge only modestly higher over the next 12 months.
Thomas Marthaler is portfolio manager, Global Investment Grade Fixed Income, at Neuberger Berman
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