2015: A Rates Odyssey

Brian Tomlinson
Written by

7th October 2015

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In a galaxy far far away…There is an inverted yield curve…But not in the United States…Not now…And the Fed (US Federal Reserve) must AVOID at all costs creating an inverted yield curve during this hiking cycle…Or else a RECESSION will hit America.

Fact: The Fed failed to raise rates at its most recent policy meeting citing non-domestic “global concerns”. I believe this was a mistake: it unsettled investors, causing unnecessary volatility in all asset classes.

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Question: Will the FED ever hike rates?

Answer: Yes, Absolutely!
When? October or December, as the Fed recently announced a raise before year end. The sooner it starts, the sooner it can stop hiking.

Question: What impact will this have on markets?

We believe that investors will then rejoice and move forward with their asset allocations…And volatility will decline!
BUT…The Fed has a delicate balancing act ahead of it.
The Fed needs to engineer a hiking cycle that does NOT cause an inversion of the yield curve.

Why?

1. An inverted yield curve has ALWAYS caused a RECESSION in the U.S.A.

See chart below: When the blue line crosses below the red line, the curve is inverted.

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Source: Bloomberg, AllianzGI, as of July 2015

What happens?  A recession comes 6 to 18 months after an inversion occurs as measured by the difference between 2 and 10 year US Govt. Treasury Yields.

2. An inverted yield curve impacts the transmission mechanism…Banks lend less when the US Government Yield Curve is inverted…The cost of their short term funds or deposits (which are liabilities) become  higher than their loans (assets)…Making it less or unprofitable to lend money…Banks borrow short and lend long!

The Yield Curve is my most important tool as a global bond and FX manager….
Why you ask?
Because it provides bond managers with a wealth of FREE information assisting them in predicting the following:

1. Current stage of a country’s economic cycle
2. It forecasts the future shape of the yield curve
3. Duration Positioning
4. Sector Allocation
5. FX strategy
6. When to expect a recession

Strategy: 5 ideas to Consider

Fact: Inflation in Europe is on an upward trajectory, therefore:
1. Implement Curve steepeners and short duration in Europe
2.  Buy Inflation Linked Bonds in Europe[1]

Inflation forecasts Source: ECB September 2015

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Fact: The Fed will hike soon

3. Implement US Yield Curve flattener and short duration

FX: The USD will rise against most currencies

4. Long USD…Until the FED signals it is done hiking rates probably in June 2016…Before the US Presidential election in November 2016

Emerging Markets: 6.5% yield in US Dollar!

5. Prepare to buy this asset class[2]…Really cheap if you have a 3 to 5 year horizon. The yield is at approximately 6.5% (JP Morgan EM Sovereign Bond Index in US Dollar)

5Source: JP Morgan index, September 2015

Conclusion

Until the Fed takes action and hikes the Fed Funds rate…We bond portfolio managers will have to continue to dance to the song of volatility.

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[1] This is no recommendation or solicitation to buy or sell any particular security.
[2] This is no recommendation or solicitation to buy or sell any particular security.