Is the party about to end?

Chris Manuell, CMT

Jamieson Coote Bonds

As an active manager of high-grade bonds, we continue to focus on the moves of the US Federal Reserve. The Fed remains resolute on its path of increasing short-term rates into the zenith of the US economic cycle, and as the world gorges contently on debt. 

The investment mantra that should always feature prominently in the investor's lexicon is: “Don’t fight the Fed”. This is particularly pertinent at the moment with the Fed and other select Central Banks increasing the cost of borrowing.

The tightening of monetary conditions has coincided with a litany of financial market skirmishes during 2018 - Bitcoin collapsing, the February equity correction down more than 10% (inspired by the short volatility ETF XIV), the emerging equity market crises of Turkey and Argentina, credit lead concerns in Italy and a surge in short-term bank funding costs in the US and Australia.

JCB remains concerned that the cost of debt is even more critical in this global late cycle, as there has been an unprecedented asset price appreciation with the assistance of Central Banks’ liquidity and also a mountain of global debt to service.

The latest eye-watering numbers of global debt (released by the Institute of International Finance) notched up another fresh all-time high of $247 trillion

We believe the context of this debt is also alarming with the marginal impact greater as we come off low levels of interest rates, the velocity of the recent uptick in debt (sign of deteriorating credit quality), and as incomes to service these debts continue to plateau.

The Fed has signaled its intention to remain on course with a gradual rate hike program, taking the Fed funds rate to its long-run estimate of around 3.00%. The European Central Bank, Bank of England and the Bank of Canada have all recently added to the chorus of faster monetary tightening in some form.

Closer to home, the Reserve Bank of Australia (RBA) will perversely be prevented from hiking as short-term borrowing costs continue to increase for Australian banks,  which they magnanimously pass on to their customers.

We believe this will prove problematic as global growth continues to lose momentum and the odds of an economic slowdown in the next 12 months continues to tighten.

The isolated financial market spot-fires that have surfaced already this year will be an entrée into a greater risk market asset revaluation, as the tightening of the financial conditions starts to snowball. The contemporary herding nature of investors will be tested again as they all look to squeeze out of the same exit door.

What signposts to watch for?

Monitoring the shape of the yield curve is the signpost for the markets at the moment. US yield curves continue to flatten with the differential between 2-year and 10-year yield at its narrowest level since 2007.

Historically, a negative yield curve is the unofficial recession prognosticator as it has called all nine US recessions since 1955, with a lag of six to twelve months.

When it tightens to 20 basis points, the probability of a recession increases dramatically as it becomes a self-fulfilling prophecy. Last week (13 July 2018) it closed at 24 basis points.

The other canary in the coal mine is credit spreads. When they widen to treasuries it is usually a concern for risk assets and validation that we are long in the tooth in the business cycle.

We monitor Euro junk-bond yields - which touched an insanely low level of 2.08% in October 2017 and have subsequently widened out to 3.4%, which in itself is still very low. 

The tightening of financial conditions from the Fed and its cohorts will impose more credit risks in these markets in the next six months. We are carefully watching the gap in yields between the lowest-rated tranche of investment grade US corporate bonds and 10-year Treasuries, as a trigger point for impending credit widening.

Historically, when the gap between BBB/Treasuries hits 200 basis points, it’s a code red for a US recession. At the moment, the spread is loitering around the 195 level, and we would like to see a confirmation with a sustained close above the 200 level.

Cross asset volatility continues to plumb the yearly lows and a pick-up in volatility is another precursor for a risk asset sell-off with JCB on alert into the seasonally shocking period for equities – September is historically the equity market's worst month.

In summary

JCB maintains the view that we are in the process of a market top for risk assets, which can take time to unfold, and as history has proven, tends to have its own different catalysts. The sharp February correction was symptomatic of a topping process as bears and short sellers always get churned.

The continued tightening path of the Fed will severely test the attempt of the US economy to complete the longest economic expansion in US history, and take the wind out of the sails of a decade-long risk asset rally fuelled on central bank liquidity.


Further insights

As we continue to face volatile market periods, bonds should generate capital gains along with their fixed interest payments, as investors seek the highest quality investments. Find out more

Chris Manuell, CMT
Senior Portfolio Manager
Jamieson Coote Bonds

Chris oversees a range of investment strategies for institutional and retail clients. He is a bond investment specialist with over 20 years of experience gained at Merrill Lynch, Société Générale and The Royal Bank of Canada, here and abroad.

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