Dear doves and hawks, the countdown is on


Monthly Fund Commentary
16 Mar 2016


In February, all eyes were focused on the ECB’s next scheduled meeting on 10th March. In the global bond market, concerns about a possible Brexit impacted the GBP bond market (both yields and currency), uncertainty about the size of Italian banks’ non-performing loans and about the exposure to the oil & gas sector on European banks balance sheets led to a drop in subordinated bank debt (including CoCos).

In addition, negative yields implemented by the Bank of Japan (BoJ) pushed the 10y Japanese government bond yield to 0%. In Europe, the amount of debt yielding less than -0.3% (i.e. not eligible for ECB purchases) reached EUR 1 trillion. In this context, European macro-economic data seemed peripheral to investors: business confidence in the Eurozone and German data were particularly disappointing, offset by stronger GDP growth in France, together with a stabilization of the unemployment data. In the US, poor data, such as durable goods orders (-5%, -1% ex-transport), ISM manufacturing (48.2, still below 50), U-Michigan sentiment (91.7) and Consumer confidence (92.2 v. 98.1 previous month), were counterbalanced by an unemployment rate symbolically below 5% (4.9% despite a disappointing change in nonfarm payrolls reaching +151k v. +190k expected). More interestingly, the average hourly earnings figure (+0.5% MoM, +2.5% YoY) showed signs of wage inflation and the CPI confirmed, with +2.2% YoY ex-food and energy, that inflation could reach 2% (1.4% YoY today) in the coming months. Regarding Central banks activity, the ECB meeting should be in line with investors’ expectations as Mr Draghi promised “no limit” and learnt from previous mistakes made in December. Consequently, the minimum expectation is for further stimulus and markets expect a positive surprise, i.e. something new and different from an already priced easing (from -0.3% to -0.4%) and a QE expansion (increase of purchases from EUR 60bn to 80bn per month). The Fed seems to be in a “wait and see” mode. Mrs Yellen said that due to economic conditions, only gradual increases would be implemented. She added that it is not necessary to cut rates but in saying that, she gives substance to the thesis that it is a possible scenario in the coming months.

In this context, the 2y US Treasury yield remained at 0.77%, the 5y yield decreased from 1.33% to 1.21% (-12 bps), the 10y from 1.92% to 1.73% (-19 bps) and the famous 30y long bond from 2.74% to 2.62% (-12 bps) with a bottom at 2.49% on 10th and 11th February when oil prices reached $26. On the credit side, the US corporate CDX index kept widening from 102 to 107 bps (reaching a peak of 125 on 11th February also due to oil prices bottoming at $26) due to continuing signs of recession in some sectors of US industry and the European iTraxx Main widened from 92 to 99 bps, led by spread widening in the banking sector, not completely offset by the rally led by issuers that may be included in the ECB’s purchase list from 10th March. Both investment grade credit markets also suffered from a “flight to quality”, investors favouring government bonds (Bunds and US Treasuries) despite their lower yields.

In February, the Investment Adviser did not change the global strategy which was implemented in June 2015, favouring high quality and liquidity. There were no corporate bond transactions during the month. However, a KfW (German government) duration extension trade was implemented: KfW maturing in March 2016 was sold against KfW 2021. More importantly, the strategy which consists of being exposed to 30y US Treasuries has been amended. This exposure actually included three different strategies:

-1: Long 30y Treasuries outright

-2: Long 30y inflation-linked Treasuries outright

-3: Long 30y Treasuries / short 2y and 5y notes futures (flattening 2-30y and 5-30y)

Given the fact that the Fed could postpone any rate hike in Q1 and Q2 2016, 2y and 5y yields could continue rallying simultaneously with 30y yields. Consequently, the third strategy (flattening) has been removed. The Investment Adviser sold the Treasury maturing in August 2044 (whole position) and bought back the totality of the short future position (i.e. 100 2y notes and 100 5y notes). In terms of duration, the Investment Adviser substantially increased the modified duration of the Fund from 4.6 to 5.2.

The Investment Adviser believes that the ECB will stay ultra accommodative and that Mr Draghi will announce an increase of the ECB’s QE in March. The economic conditions are not particularly improving in the Eurozone with weak growth and, more importantly (as it is the unique mandate of the ECB) low inflation. In this respect, the ECB decreased sharply its forecast for inflation this year from 1.1% to 0.25% (and from 2% to 1.75% for its 2017 projection). Regarding the Fed’s policy, the behaviour of the FOMC in 2016 is still unclear: inflation is low, oil prices reached a bottom this month, international issues are growing (Emerging markets, China in particular) and the Fed is expecting four rate hikes (25bp/Quarter) while markets are not pricing in any hikes (the 2y Treasury note yield remained at 0.77% which is too low compared to the Fed dot-plots). Already 13% of investors think that the Fed could adopt negative rates in 2017 (potentially as a result of the Fed announcing that in the next bank stress tests, a new scenario will be added with 10% unemployment rate and negative Treasury yields).

The Investment Adviser is still extremely cautious on corporate spreads and on liquidity in the credit market. He will continue to focus his investments on high quality corporates and government agencies. High beta names will be avoided except short maturities with a “buy and hold until maturity” strategy. The modified duration of the Fund may increase above 5.5 as any rebound of 30y Treasury yields above 2.75% would be an opportunity to increase investments in long bonds. Investment Adviser still believes that positive returns will be achievable as a result of the carry of government-owned bonds and high-quality corporates, their spread tightening potential, credit selection and active management of duration and yield curve.

The views and statements contained herein are those of Sturdza Private Banking Group in their capacity as Investment Advisers to the Fund as of 14/03/16 and are based on internal research and modelling.