Monday, April 12, 2010

Asset Allocation - International Fixed Income

A few entries ago I mentioned that I was preparing for a quarterly asset allocation meeting and promised to share my thinking on the two asset classes I am responsible for - fixed income and currencies. Below please find a brief summary but please, this is not investment advice, it is food for thought....

2009 was clearly a great year for virtually all fixed income. Central banks around the world cut rates in hopes of preventing economic disaster, and by and large they did. By cutting short term rates to near zero, while credit spreads were wide, huge amounts of money poured in to credit products of all kinds tightening spreads dramatically. Since the saver got and still gets literally nothing to stay in short term cash equivalent instruments, the incentive was huge to look for incremental income whether one could find it. This opportunity and incentive, combined with government action in terms of ‘quantitative easing” leaves us where we are today. Spreads across all sectors have tightened dramatically, and it could be argued that overall rates are artificially low because of government purchases, again particularly in the US.

So what next? The direction of interest rates is clearly dependent on economic growth, and this is where we already have begun to see major differentiation by country depending on how quickly their economies have rebounded. Where growth has picked up, and concerns about inflation have begun to take hold, rates have been moving higher. In the US fed funds have remained at zero and there are mixed views as to when it will move higher. A few economists are calling for slightly higher rates by year end, and many others believe the fed will remain on hold well in to 2011 in fear of adding pressure to the housing market and choking off a possible recovery. Where the fed has less control obviously is the longer end of the curve. 10 year rates have been rising and are at the higher end of their recent range, pushing towards 4%. Most economists think that US rates are headed higher overall with a steep yield curve continuing.

What about spread products? In the US it is clear that the massive $1.7 trillion of fed purchases of MBS, Agencies and Treasuries has worked to keep both rates down and spreads tight. Given the treasury has already said they are stopping their purchase programs it seems logical that spreads should widen UNLESS of course other buyers emerge which I and most of the folks I read doubt. There has been significant supply in all sectors in Q1 but particularly in US Treasuries. US corporate issuance was $225 billion in Q1, High Yield was $67 billion, Treasuries $601 billion. So bottom line I would expect at a minimum for the tightening of spread products to end and pressure coming because of supply. On the positive side however, with cash yields anchored at zero, the positive carry of high quality credit remains attractive.

In summary – Q2 may prove a much turning point for the global bond markets on average. For countries experiencing an economic recovery rates may move higher to protect from higher inflation. This may also prove true for the US, but the more likely scenario is the absence of government purchase programs, combined with lots of supply, but pressure on both rates and spreads.

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