By Eric Vanraes and Pascal Perrone
In October, the European Central Bank (ECB) kept interest rates unchanged and started its covered bonds purchasing program. ECB President Mr Draghi announced an increase of the bank’s balance sheet by as much as EUR 1 trillion in order to fight deflation in the euro area.
During the month, German economic data proved hugely disappointing, the Ifo Business Climate Index had fallen to its lowest point since August 2012 and economic growth forecast of Europe’s largest economy growth was revised down to 1.2% in 2014 and 1.3% in 2015. In the US, volatility increased sharply due to increasing uncertainties regarding the behaviour of the Federal Reserve (Fed). On one hand, the Fed announced the end of QE3, where Mrs Yellen, Chair of the Board of Governors indicated that the decision was based on, “solid job gains and a lower unemployment rate”. On the other hand, Mr Bullard (Federal Reserve Bank of Saint-Louis, Missouri, known as the hawk who wanted to raise Fed Fund rates just after the end of QE3) was dovish about the Fed’s decision and did not exclude another round of QE in 2015. Despite better housing and employment data in the US, consumption and manufacturing data were disappointing.
At the end of the month, the Bank of Japan’s shock move to increase its asset purchases by JPY 30 trn to JPY 80 trn a year, and the Fed’s decision to end its QE programme focused attention on the ECB’s own quantitative easing program. Over recent months, the euro area has been battered by economic stagnation and the increasing risk of deflation, resulting in higher expectations that the ECB may follow Tokyo’s lead.
During the month, the yield of 2-Yr, 5-Yr, 10-Yr and 30-Yr Treasury notes decreased by 8bps, 14bps, 15bps and 13bps, respectively. On the credit side, investment grade corporate spreads in the US remained unchanged and credit spreads in Europe increased slightly: the CDX Index stood at 64 bps and the iTraxx Index edged higher from 63 to 65 bps.
Investment Adviser remains convinced that the slope of the US Treasury curve is likely to flatten substantially in the coming months.
The assets of the Fund increased further during the month from USD 111 to USD 113 million. During the month of October, there were some changes to the asset allocation, where the Fund’s exposure to Chilean companies (Codelco & Enap) was reduced due to falling copper prices and worsening Chilean macro-economic conditions. The proceeds were reinvested by increasing exposure in Chinese issuers (China Uranium & Sinopec). Finally, as the Investment Adviser remains convinced that the slope of the US Treasury curve is likely to flatten substantially in the coming months, they increased the Fund’s exposure to the long end of the curve by buying a position in Temasek 2042 (Singapore sovereign fund AAA rated) and increased the Fund’s position in 30-Yr US Treasury hedged by a short 5-Year US Treasury futures. This flattening strategy has been done at a spread of 146 bps (30-Yr at 3.06% and 5-Yr at 1.60%). At month end, the Fund held 48 issues and 45 issuers.
Regarding the duration overlay policy, the Investment Adviser increased the modified duration of the Fund during the month from 4.4 to 5.13. It is their belief that the US Treasury curve will continue to flatten and as such they will maintain the Fund’s short 5-Yr and 10-Yr US Treasury futures positions.
• Modified duration of the portfolio: 6.18
• Modified duration of the short Future positions (5 & 10 year note): -1.02
• Modified duration of the Fund: 5.16
In the coming weeks, the Investment Adviser will stay pragmatic and adapt their duration policy according to the Fed’s behavior, which is as unclear and illustrated by its recent statement: “If incoming information indicates faster progress toward the Committee’s employment and inflation objectives than the Committee now expects, then increases in the target range for the federal funds rate are likely to occur sooner than currently anticipated. Conversely, if progress proves slower than expected, then increases in the target range are likely to occur later than currently anticipated.
At the same time, the Investment Adviser will pursue their corporate bond picking process and remain highly selective. In addition, they will stay very cautious towards Emerging Markets and High Yield. Consequently, we are still confident that positive returns will be achievable thanks to the carry of corporates, their spread tightening potential, the credit selection and a very active duration and yield curve management.
Commentary provided by Banque Eric Sturdza in their capacity as Investment Advisers to the Fund as of 11 November 2014