Latest G10 Macro Rates Blog - Touching the Extremes
With Shayne Dunlap, Co-Portfolio Manager
Touching the Extremes
Recent market moves have been extreme with multiple markets making new records and volatility picking up to the levels not seen since 2016 US elections.
The shock of increasing and prolonged antagonism of the Trump-China trade negotiations, combined with “Hard” Brexit probabilities and worse than expected economic data from Asia has sent the investment community into recessionary panic mode. There has been an increasingly frenetic grab for yield, sending some markets entirely negative such as the German bund curve. This demand is best exemplified in the chart below of the UST 30yr dropping below 2% for the first time in history.
As per step one of our process, we have always said we are not forecasters and are not going to start now. Our process has always been about looking at the available data and to a certain extent the consensus economic view and work out whether this is reflected in market pricing. The current economic consensus, one we agree with, is that robust consumer demand in many countries combined with historic low unemployment rates and rising real wage gains will offset some of the economic drag from trade-related uncertainty and prevent a global recession. Current market pricing is far more pessimistic than the economic consensus or data suggests. This has warped many relationships across interest rate markets to be at or near extreme levels.
Further, our investment process relies on analysing these relationships and finding the best risk-reward opportunities. We have been using these opportunities to enter trades that benefit from the markets pricing a more balanced economic outlook. Unfortunately, escalating trade wars in conjunction with continued weakness in global manufacturing lead to a panic behaviour in the markets that triggered stops at levels not seen in decades, if ever. An example below is a trade we have had to unwind. It was an interest rate swap butterfly in Canada 5y-10y-15y where we were short the middle 10y and long rates in 5y and 15y. Our stop at approximately +7bp had held firm since data began in 1994.
Globally curves have drastically flattened on the back of the international grab for yield. We view the potential for a change to a more positive outlook as being high. It is not difficult in our eyes to imagine that Central Bank cuts, combined with more non-conventional policy such as QE are supplemented with an easier fiscal policy as being discussed by governments in the US, UK, China, Japan and Europe. These policies should have a positive effect on growth, not being discussed by market commentators and sending the forward yield curve into a steeper trajectory. This is at odds with the current inverted curve and recessionary talk that currently fills the airways. The symmetry of the rally and flattening in many global rates curves could reverse in a similar fashion.
Other markets have also reached extremes. Equity, bond and IG credit returns have been strong, and many investors have had a dream run. It is becoming increasingly difficult to see how recent returns can continue at the same pace with many sovereign bonds now trading negative, equity p/e ratios high and IG Credit spreads and yields at historic lows. What does an allocator do when faced with this predicament?
The stretched bond markets combined with US stock markets at record levels means that the vulnerability to a combined selling of both bond and equities would cause much damage to many investment portfolios as the traditional risk parity balance between the two main asset classes is no longer there. Returns have been good during the good times, what is there to protect returns if things go bad? G10 Macro is a strategy that can benefit in such a scenario.
It’s worth noting, we are not a contrarian fund. The extremes that are being priced into forward curves of many countries relative to the economic data are naturally leading us to look for reversals via our validation process. We understand and respect the nervousness in markets and have had portfolio risk decreased naturally via our stops but are actively looking for an opportunity where data and/or news increases the probability that an extreme is in place, so many of the great opportunities currently viewed can be implemented.
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