Federal Reserve governors have stated on many occasions that the central bank's decision on when it will raise interest rates will be data dependent. Thus far the data have supported no movement, and that is exactly what the Fed has done. A muted inflation backdrop has given the Fed the ability to move slowly.
The tepid pace of wage growth plays into Fed Chair Janet Yellen’s stated view that the U.S. employment situation remains challenging, and that more accommodation is needed to create additional growth to boost both the labor participation rate as well as median household income.
The longer the Fed waits the more the markets will try and anticipate such growth and get ahead of the Fed. This played out during Q2. The long end of the bond markets in the U.S. and Europe witnessed material corrections from the March/April rally, which followed the introduction of ECB quantitative easing. Interest rates at the 10-year and 30-year points on the yield curve have backed up 50-70 basis points in the U.S. and 80 to 120 basis points in Germany. Whatever the cause for the correction, markets now appear more balanced with respect to risk. Long assets are volatile and responsive to economic news as the Fed is the first major central bank on the verge of tightening.
Assuming economic data remains on pace, I expect the Fed to move at least once to get rates off the zero bound later this year. An impetus for a second increase later this year may come from the fact the Fed rarely likes to influence monetary policy during an election year.
Against this backdrop, where is the opportunity?
One of the key factors in today’s markets is that investor flows are of ever-increasing importance in setting the direction of the markets. The shock absorber of bank balance sheets and proprietary trading, which historically would have positioned these flows for their own profit, is long gone. This was the intent of the post financial crisis regulatory changes and is today’s reality.
Today, investor flows are moving prices more than we have been accustomed to for several decades. This creates an opportunity for relative value trading. Recognizing when supply and demand pressures cause price overshoots relative to the likely future state of the ‘world to be’ creates investment opportunities.
One example of such opportunity today is the dislocation in the fair value of closed-end funds (CEFs). Retail aversion to leveraged longer maturity fixed-income assets, which are held by much of these products designed to have a high carry/yield, has widened discounts on CEFs to near historic levels. These discounts to net asset value (NAV) offer incremental yield for investors given one is buying assets at 90% of market value and additionally affords the opportunity for capital appreciation from capturing changes in the level of the discount.
Another opportunity arises from decreased willingness by dealers to warehouse residual risks from structured retail note issuance. Many of these notes are tied to the price appreciation of various equities, equity indices, and currencies, often with highly tailored payouts. The originators hedge the notes' performance using the underlying stocks/indices/currencies themselves and additionally with derivatives such as options and other basic volatility and dividend products. When banks hedge these risks in the market, distortions and dislocations are created particularly when the ability of banks to warehouse such risks is constrained by regulators, stress tests, and generally lower risk appetite among the dealers. This creates the opportunity to structure portfolios to take advantage of such dislocations on a relative value basis or, in some cases, by structuring directional trades with particularly attractive entry levels.
Lastly, a theme I have been touting for the past 12 months is that of inefficiencies in the global sovereign bond markets. As Fed policy begins its next chapter, risk premiums on the long-end of the yield curve will increase and changing views about term structure risk as well as developing policy implementation will continue to elevate bond volatility. One would think that initially much of the activity will be focused on the U.S., however, I believe as the U.S. economy recovers, positive knock on effects will occur in Europe. Given the backdrop of a QE policy likely to remain in effect for another year, and the low absolute level of interest rates, Europe could prove to be a more interesting market place for tradable dislocations than the U.S.
I believe the economic environment has likely shifted. The path of economic growth is upward sloping and sustainable. This will result in higher levels of short-term policy rates and more volatile longer-term rates. This backdrop will generally be unfriendly to the equity and credit markets, making it difficult to extract much return from long-only portfolios. Strategies that can successfully trade through volatile markets which benefit either from a defined event, or are able to capture the noise in what is otherwise a directionless market, are likely to outperform.
