With interest rates having remained at historic lows for years now, many fixed income managers have come to term the current environment as the ’new normal’.
However JP Morgan Asset Management fund manager Bill Eigen is wary of the risks of relying on interest rates remaining so low and warns that undiversified portfolios may struggle in the eventuality of a rate rise.
Eigen, who manages the $10.4bn (£6.1bn) JPM Investment Funds Income Opportunity fund, has picked out four myths he sees bond investors still believing and outlines what the realities are.
Myth: US Treasuries provide higher yields than other, similar sovereign bonds
“In an efficient market, interest rates reflect expectations for economic output growth and inflation,” explains Eigen. ”Rates in Europe are lower partly because inflation and GDP growth remain and are expected to remain low.
“Conversely, US rates do not properly reflect the moderate GDP growth and higher inflation that is expected in the second half of 2014. Therefore, US nominal yields are trading at ‘discounted’ levels to what the appropriate real yield should represent. Diverging growth patterns mean the eventual untethering of yields.”
Myth: Subdued growth expectations means lower interest rate risk
“Predicting factors such as central bank policy, housing market growth and capital expenditures that determine long-term growth rates years into the future can be futile. Even when armed with data, investors have a history of undershooting fed funds rate changes,” says Eigen.
“In the last Fed tightening cycle, the market’s expectations of the timing and magnitude of fed funds rate changes fell short. We believe this same dynamic is occurring again today. The Fed has stated a target of a 2.5 per cent for the fed funds rate by the end of 2016 while the market’s priced-in expectation is 1.75 per cent.”
Myth: Shrinking deficit means less US Govt debt issuance
“While the US deficit has shrunk, the debt burden is still massive and servicing that debt will be a monumental task requiring more debt to be issued. This will lead to a healthy supply of US Treasuries as the country continues to fund its debts,” says Eigen.
”The Fed has been the largest buyer of Treasuries; it accounted for most of the net purchases in 2013. With the Fed leaving the market as QE is expected to wind down, who will come in and pick up the slack? A waning of demand could force rates higher in order for new debt to be absorbed by the market.”
Myth: An accomodative Fed for several more years
“While the Fed can be committed in the short term, the economy may force its hand,” says Eigen.
“The labor market has improved markedly over the last few months, inflation has drifted higher and the economy is poised for stronger growth. The Fed is still implementing credit-crisis-like policy, while the pattern of moderate economic growth suggests that it may be superfluous. Ultra-low rates for the last six years and massive amounts of quantitative easing will need to be unwound. As growth becomes more consistent, the Fed may be forced to tighten quicker than anticipated.”