Sponsored article: Kerry Duffain looks at the challenges facing treasury managers and the prospects for “relative value” investing in fixed income.
Markets have been buffeted by hawkish central banks and surging inflation.
The last month has seen massive shifts in shorter maturity bond yields and interest rate swaps. Around the world central banks have backed away from dovish policy guidance, sparking a major regime shift in expectations for future policy rates. Market moves have been exacerbated by hedge funds and other speculators jettisoning lower-for-longer interest rate bets.
This theme is evident across the world, but the UK has been among the most volatile markets. In the month of October, some shorter-term gilt yields registered their largest monthly increases since 2009 and the GBP swap market has moved to price an additional 70bp of Bank of England (BoE) policy rate tightening over the next two years.
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This repricing was partly sparked by key BoE policy committee members citing rising inflation expectations as a reason to soon begin tightening policy. UK consumer price inflation has surged to a decade high of 4.2% (annual change) and could eclipse 5% in the coming months as high energy prices feed through to households. Markets were surprised when the BoE chose not to hike at their November meeting, but hikes seem a matter of when and not if.
Unlike the approach of previous rate hike cycles, however, markets seem much more relaxed about just how high the BoE policy rate will eventually reach (not much over 1%). The prospect of a short, but fast, rate hike cycle means that longer-term gilt yields and equity markets have so far been remarkably stable in the face of higher volatility in shorter term yields. This yield curve disconnect is unusual and may not last.
The accuracy of economic forecasts and the reliability of central bank guidance is now under much greater market scrutiny. There are some good reasons to believe central bankers when they tell us that inflation pressures will be “transitory”. But just what length of time is defined by “transitory” is an open question. The longer price pressures persist, the greater the risks to growth stability and central bank credibility. The next phase of the recovery could see macro uncertainty reach new extremes.
Relative value alternatives for navigating turbulent interest rate markets
Looking ahead to 2022, this macro backdrop presents significant challenges for treasury managers seeking reliable, low volatility returns from fixed income. Simply buying and holding bonds means greater risk of capital losses if inflation pressures persist and the BoE remains skittish. Even if inflation pressures do subside, the path for yields is likely to be anything but a straight line.
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Fortunately, there are alternatives to trying to generate returns by buying and holding bonds or timing movements in yields. One lesser known, but nonetheless long-standing approach to fixed income is pure “relative value” (RV) investing.
Pure RV investing does not rely on conventional fixed income return sources and is therefore unaffected by whether bond yields are high, low or even negative. Nor is it reliant on credit risk or trying to predict direction of interest rates.
Instead, a pure RV approach focuses on pricing inconsistencies between closely related securities. These strategies also make use of interest rate options to protect portfolios and directly benefit from an environment of rising interest rate volatility.
Kerry Duffain, Institutional client Solutions, Fidante Partners.
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