Money managers are making the most of diverging interest-rate policies around the world. At the same time, though, they are cautious as near-term economic outlooks in the U.S., the U.K. and the EU change rapidly.
Monetary policy has been the loosest in the U.S., whereas the European Central Bank already raised its target rate by 25 basis points on April 7. Meanwhile, most experts forecast the Bank of England's Monetary Policy Committee would raise rates in May, which never happened. Instead, experts now say a rise won't likely happen until early next year.
“You get quite a lot of opportunity out of” the variations among the central banks, said Nick Gartside, managing director and international chief investment officer for fixed income at J.P. Morgan Asset Management, London.
J.P. Morgan managers are betting that eurozone countries will have more of a yield-curve-flattening bias than the U.S. and U.K., and they're looking for cross-market trades. Portfolio managers are long on the front end of the U.K. yield curve and short on the front end in the eurozone.
Mr. Gartside expects to make more trades like that as the U.S. and U.K. start to tighten their rates, something that's not expected to begin to happen until 2012. “It's pretty early days yet,” he noted.
Cedric Scholtes, a portfolio manager at Fischer Francis Trees & Watts Inc., New York, has worked for both the Federal Reserve Bank of New York and the Bank of England. He said the move by the U.S. to end quantitative easing — so-called QE2 — in June is “one small step” toward tightening monetary policy. And he views 10-year Treasury notes as an investment opportunity.
Mr. Scholtes sees “reasonable resilience in the U.S. economy, in part because household income has grown and household debt has eased.”
“We're making slow but steady progress in the U.S., and yet, in the Treasury market, we're getting valuations close to where they were last summer.” Yields on 10-year notes bumped around at 2.5% in August through October 2010 and are threatening to fall below 3%. “We think the expectations being priced in at the moment are probably unduly pessimistic,” Mr. Scholtes said.
Active global bond managers say market volatility usually provides excellent opportunities to outperform benchmarks, which is true in the current environment. However, they note that the waters are particularly choppy today, with global growth projections and political crises — like the one involving sovereign debt in Europe's peripheral countries — being in seemingly constant flux.
“You have to be very careful not to get whipsawed all the time,” said Jon Day, fixed-income fund manager at Newton Investment Management Ltd., London. “There are a lot of ways you can get it wrong.”
Newton captured narrowing spreads on U.K. gilts as they provided a safe haven for European debt investors troubled about the crisis in peripheral countries such as Greece, Ireland and Portugal, which have needed bailouts because of mounting debt. But because spreads moved so much in the past two months, Mr. Day doesn't like the immediate future for gilts. “It's gotten more difficult now,” he said. “Bond markets in general are quite difficult.”
Said Christophe Pella, vice president and senior investment manager in active fixed income at State Street Global Advisors in London: “Volatility cuts both ways. The fact that there are more moving parts makes (the environment) ripe. But a lot of the volatility comes from political factors … which are hard to predict.”
SSgA took advantage of expectations that the European Central Bank would tighten its rates by going long on U.S. Treasuries and short on German bunds for two-year notes. The difference between the two widened by 100 basis points in the past 11 months.
Managers interviewed said they prefer debt from countries such as Australia, Canada, Sweden and Norway, which already have begun to raise rates, to that from the big three markets.
The eurozone is the only market among the big three that has begun to raise rates. Thomas Kressin, Munich-based senior vice president and portfolio manager at Pacific Investment Management Co., said the ECB is still in the process of “normalizing” rates. He said the current policy rate of 1.25% is still a stimulus, as inflation is near 3% in the eurozone. “That still means you have negative real interest rates,” he said.
Negative real rates creates what PIMCO calls “financial repression,” meaning savings and the value of social benefits are declining in countries with negative real rates.
Jonathan Cloke, head of global government bonds at Legal & General Investment Management Ltd., London, said managers are struggling with the current volatility “because people want to be underweight bonds, but the news flow is working against those positions (and is) leading to a flight-to-quality bid, which isn't helping people's underweight positions.”
Portfolio managers at Aberdeen Asset Managers Ltd. have made hay on being underweight the risky debt of peripheral European countries vs. core ones such as German bunds. Jonathan Cunliffe, London-basedco-head of interest rates and global fixed income at Aberdeen, said U.K. gilts also have provided a safe haven during the European debt crisis.
“Clearly the U.K. bond market is giving the U.K. authorities a reasonable amount of support at the moment for the steps that have been taken” to lower deficit spending, he said. Still, Mr. Cunliffe noted that inflation could prove to be a problem, and that the U.K.'s austerity package could dampen growth. “This is about as good as it gets at the moment for gilts,” he said.
While the ECB has been very clear about wanting to handle inflation, the Bank of England has been much harder to predict because the Monetary Policy Committee's members are “almost too democratic” in their diverging opinions, J.P. Morgan's Mr. Gartside said. For example, at their May meeting, MPC members voted 6-3 in favor of leaving rates alone.
“Market expectations have changed a lot” in just three months, Mr. Cloke said, as 100 basis points of rate hikes in 2011 have been cut out of expectations. No rate hikes are now being priced in until early next year.
Aberdeen's strategic outlook for the U.S. is also grim. “We are looking for some negative news flow on public finances, which hasn't been addressed,” Mr. Cunliffe said. “There are concerns ahead.”
Countries like Australia and Norway, however, benefit from higher commodity prices and were not as badly hit by the global financial crisis, said PIMCO's Mr. Kressin. PIMCO and other bond managers prefer to invest in these developed — and emerging — countries because they have more manageable debt loads, better growth and stronger long-term prospects.
“Rising inflation pressures in the emerging world, combined with strong growth should lead to more willingness to allow currency appreciation,” Mr. Kressin said. “For us, it's a win-win to move out of government bonds in developed countries and into local-currency debt of emerging markets governments” that have good debt dynamics.
Said Ranjiv Mann, chief economist and bond manager at Rogge Global Partners PLC, London: “There's certainly some interesting opportunities out there if you look at the differences between growth in the emerging and developed worlds.
“Even in Europe, we think the market is pricing in too many rate hikes.”