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

Bonds
Althea Spinozzi

Senior 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 is not intended to and does not change or expand on this. 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/en-hk/legal/disclaimer/saxo-disclaimer)

Saxo Capital Markets HK Limited
19th Floor
Shanghai Commercial Bank Tower
12 Queen’s Road Central
Hong Kong

Contact Saxo

Select region

Hong Kong S.A.R
Hong Kong S.A.R

Saxo Capital Markets HK is a company authorised and regulated by the Securities and Futures Commission of Hong Kong. Saxo Capital Markets HK Limited holds a Type 1 Regulated Activity (Dealing in securities); Type 2 Regulated Activity (Dealing in Futures Contract) and Type 3 Regulated Activity (Leveraged foreign exchange trading) licenses (CE No. AVD061). Registered address: 19th Floor, Shanghai Commercial Bank Tower, 12 Queen’s Road Central, Hong Kong

By clicking on certain links on this site, you are aware and agree to leave the website of Saxo Capital Markets, proceed on to the linked site managed by Saxo Group and where you will be subject to the terms of that linked site.

Apple, iPad and iPhone are trademarks of Apple Inc., registered in the US and other countries. AppStore is a service mark of Apple Inc.

Please note that the information on this site and any product and services we offer are not targeted at investors residing in the United States and Japan, and are not intended for distribution to, or use by any person in any country or jurisdiction where such distribution or use would be contrary to local law or regulation. Please click here to view our full disclaimer.