At the start of June, European Central Bank president, Mario Draghi, told journalists that markets should get used to higher levels of volatility.
“At very low levels of interest rates, asset prices tend to show higher volatility,” he said, following the ECB’s monetary policy meeting.
The comments reverberated through fixed-income markets, with German bunds, in particular, reacting sharply.
Most bond market sectors have been perceived differently for the past few decades – as the dull, if dependable, shock absorbers of a portfolio, designed to provide stable returns during equity bull markets and a safe place on which to land when equities fall.
But, if the past 30 years have largely been one-way traffic for bond investors, the past six months have been anything but and, if Draghi’s comments are to be believed, the second half of the year will likely be equally as nerve-wracking.
Indeed, James Sullivan, portfolio manager at Coram Asset Management, told Portfolio Adviser around the time of Draghi’s comments (and the German 10-year bund’s worst 48 hours since the euro’s inception) that it was good to see some of the heat come out of asset markets.
And, while valuations remain high, he thought the moves could represent something of an inflection point. So what has changed?
The big squeeze
As with anything that has been compressed, there is only so far one can go before the pressure becomes too much and some must be released or a violent explosion will occur.
In the case of 10-year bunds, at least part of the equation was investors’ realisation that a yield of 0.06% was far too low and so we saw that yield rise.
T Rowe Price fixed-income specialist Stephane Fertat says that many people have been buying bonds without really knowing why, other than expectations surrounding ECB quantitative easing, for example, which, in his mind, helps to explain such unjustified valuations.
“The market exodus we saw recently was a wave of selling in what investors could exit easiest and quickest, for example, the more liquid bund,” Fertat says.
According to Sullivan, when that happened the ‘risk-free rate’ – a phrase that is something of an oxymoron with bonds at sub 1% – moved higher, leaving parts of the risk universe horribly exposed to weakness, and what was witnessed in early June was that being put right.
The second factor to be aware of is the increasing divergence in central bank policy, particularly between the US and the UK on one side and the Bank of Japan and the ECB on the other.
At the moment, says Guy Dunham, manager of the Baring Strategic Bond Fund, fixed-income markets globally are focusing on two issues – one looming, one ongoing.