Federal Reserve's dovish state of mind puts quality assets at risk

Bonds
Althea Spinozzi

Fixed Income Strategist

Summary:  By maintaining monetary policies easy but letting long-term yields free to move, the Federal Reserve gives support to lower quality credits while putting quality at risk. We are heading towards an unprecedented duration event that will weight on high duration assets, which in the bond market are concentrated within the investment-grade corporate space. The US investment grade (IG) corporate bond sector is heading to the worst quarter since 1981, with the utilities and communications sectors being more exposed to rising interest rates than others. The technology sector, which saw stellar valuations in the stock market last year, is characterized by a duration of eight and a half years, which matches the US IG average.


The market doesn't care about the Federal Reserve's dovish state of mind. The Fed said it itself: the economic outlook is improving substantially with inflation destined to rise together with the country's GDP, while the labour market gets stronger. Nevertheless, the central bank decided to stand still and continue with its accommodative monetary policy. This decision leaves the market with the only option to take the situation into its own hands and dumping Treasuries that will inevitably lose value.

The steeping of the US yield curve resumed this morning with the curve's belly and the benchmark 10-year yields rising faster than long-term US Treasuries. The big issue is that if economic forecasts and inflation expectations continue to rise, rates will not stabilize until the Federal Reserve decides to intervene and engage in the infamous yield curve control (YCC). In our view, YCC will be unavoidable because, although the market can function with higher rates now, the higher they go, the more the pain that will be inflicted on those assets with historically high durations.

The market is talking about 10-year yields hitting 2%; however, if the Federal Reserve continues to keep watching, they might rise much further. The Fed has been able to maintain easy financial conditions by keeping real rates negative. However, they will not stay negative forever. In normal circumstances, nominal yields should price over the breakeven rate. It means that if inflation expectations continue to rise, we inevitably will see 10-year yields rising above 2.3%.

Source: Bloomberg and Saxo Group.

A broad cross-asset selloff might spark from high-grade credits  rather than junk

Yesterday’s FOMC meeting and today’s selloff in sovereigns reinforce our belief that we are witnessing a historical duration event. The investment-grade corporate bond market will fall faster than junk within this context because of its sensibility to higher duration. Indeed, while the average duration within junk is around three and a half years, the investment-grade bond space carries a duration of more than 8 years. Duration within quality credits has recently increased dramatically: in the past two years, duration has increased by one year and a half. To put things into context: it took four years after the global financial crisis for the duration to increase by as much.

Source: Bloomberg and Saxo Group.

If we put Treasuries into the equation, we would see that in 2013 amid the Taper Tantrum, 10-year yields rose by 130 basis points; however, investment-grade corporate bonds fell only by 2%. This year Investment-grade corporate bonds have fallen already by 3.36%, the most in forty years, with 10-year yields rising only by nearly 85bps showing that duration is a bigger threat than credit quality. Indeed, by maintaining monetary policies easy, the Federal Reserve gives support to lower quality credits on one hand. On the other, by letting long-term yields move freely while inflation expectations are rising, the central bank puts quality at risk. And who sits on quality? Everybody, more in particular real money with long-term strategies such as insurances and pension funds. And again, it is deja-vu: we might be headed towards another Global Financial Crisis?

Source: Bloomberg and Saxo Group.

As the yield curve continues to steepen will be essential to limit interest rate sensitivity. It will be interesting to know that the sectors that carry the highest duration are the communication and utility sectors whose duration is well above 10 years. The technology sector is within the US IG average, with around eight years and a half in duration. For those looking for quality while reducing duration sensibly, high-grade financials provide 6 years duration, almost half than that offered by the communications and utility sectors.

Disclaimer

The Saxo Bank Group entities each provide execution-only service and access to Analysis permitting a person to view and/or use content available on or via the website. This content is not intended to and does not change or expand on the execution-only service. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Saxo News & Research and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Bank Group by which access to Saxo News & Research is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Bank Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Bank Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Saxo News & Research or as a result of the use of the Saxo News & Research. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Bank Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. Saxo News & Research does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws.

Please read our disclaimers:
Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)
Full disclaimer (https://www.home.saxo/legal/disclaimer/saxo-disclaimer)
Full disclaimer (https://www.home.saxo/legal/saxoselect-disclaimer/disclaimer)

Saxo Bank (Schweiz) AG
Beethovenstrasse 33
CH-8002
Zürich
Switzerland

Contact Saxo

Select region

Switzerland
Switzerland

All trading carries risk. Losses can exceed deposits on margin products. You should consider whether you understand how our products work and whether you can afford to take the high risk of losing your money. To help you understand the risks involved we have put together a series of Key Information Documents (KIDs) highlighting the risks and rewards related to each product. The KIDs can be accessed here or within the trading platform. Please note that the full prospectus can be obtained free of charge from Saxo Bank (Switzerland) ltd. or the issuer.

This website can be accessed worldwide however the information on the website is related to Saxo Bank (Switzerland) Ltd. All clients will directly engage with Saxo Bank (Switzerland) Ltd. and all client agreements will be entered into with Saxo Bank (Switzerland) Ltd. and thus governed by Swiss Law.

The content of this website represents marketing material and has not been notified or submitted to any supervisory authority.

If you contact Saxo Bank (Switzerland) Ltd. or visit this website, you acknowledge and agree that any data that you transmit to Saxo Bank (Switzerland) Ltd., either through this website, by telephone or by any other means of communication (e.g. e-mail), may be collected or recorded and transferred to other Saxo Bank Group companies or third parties in Switzerland or abroad and may be stored or otherwise processed by them or Saxo Bank (Switzerland) Ltd. You release Saxo Bank (Switzerland) Ltd. from its obligations under Swiss banking and securities dealer secrecies and, to the extent permitted by law, data protection laws as well as other laws and obligations to protect privacy. Saxo Bank (Switzerland) Ltd. has implemented appropriate technical and organizational measures to protect data from unauthorized processing and disclosure and applies appropriate safeguards to guarantee adequate protection of such data.

Apple, iPad and iPhone are trademarks of Apple Inc., registered in the U.S. and other countries. App Store is a service mark of Apple Inc.