20th November 2017

“QT” is upon us. Quantitative Tightening. The unwind of the greatest monetary experiment in modern history. Is this the dawn of a new era in central bank policy? Well if it is, the markets are thus far decidedly nonplussed. In what has become a familiar theme, new lows in volatility were seen in November with both the VIX and MOVE Indices (Treasury volatility) falling to record levels. Just as the central banks would like it then…Nothing to see here. But as the perceived veneer of QE begins to wash away, perhaps there might be something to see after all.

We have highlighted in previous commentaries various pockets of volatility that have begun to emerge in areas of the global financial markets. In our fixed income world, currencies are often one of the first areas to oscillate. Within this, local emerging markets are particularly susceptible. Recent US dollar strength coupled with heightened political risk in certain areas has seen local EM decline some 5% from September highs. Turkey and South Africa have been the main underperformers within this universe. Hard currency has not been totally immune either, with spreads on Middle Eastern sovereign USD bonds jumping 80 bps in aggregate on instability emanating from Saudi Arabia.

In developed market credit, we have seen a widening in the US and EU space which could be the initial signs of a “second wave” of repricing. It is of course early days but some interesting moves have been seen nonetheless. 5 year European Xover flirted with the 260bps level, which was the most recent high for the index. Admittedly 250bps[1] on Xover is still 100bps tight of the 52 week high of 351bps. US High Yield ETFs also saw material outflows, with some $5bln of withdrawals in the week to 15 November[2]. Looking under the bonnet, EU HY appeared to be the worst affected, which we feel is no coincidence. This may be indicative of “last in – first out” behaviour where most recently issued bonds shake out first in a sell-off. The widening effect was amplified by the fact that some of these recent deals were at the more speculative end of the HY market, with a rating of single B or equivalent.

The short term change in sentiment and liquidity conditions exacerbated moves at the more speculative end of the Investment Grade market too. For example, Steinhoff, an integrated global retailer (which owns Poundland) raised a Baa3 rated €800m 2025 bond with a 1.875% coupon in July. This bond gapped down 10 points after allegations of an undisclosed related party transaction[3] in early November, While a widening following bad news stories is expected, the magnitude of the move is indicative of dealers’ lack of appetite to own inventory in a falling credit. Conversely, within higher grade financials banks continue to maintain investor friendly behaviour with respect to calling legacy bonds. This month Barclays and KBC issued call notices on legacy subordinated bonds that are callable in December and January respectively. The recent sell off did not appear to dent sentiment (or pricing for that matter) in the EUR IG market, demonstrated by the first BBB bond to be issued at negative yields. The issuer in question was Veolia, who issued 3 year paper at -0.026%.

Looking ahead, with the Fed expected to hike for a 3rd time this year and data in both the US and Europe looking strong, there is potential in our mind for a rise in benchmark bond yields. As active managers we believe fundamentally in strategies that can both manage and capitalise on volatility. If indeed we are coming to the end of an unprecedented decline in market volatility and the unabated rise of passive investment strategies, now more than ever investors will need to be active.

Steve O’Hanlon

[1] As at 15 November Close

[2]FT.com

[3] Reuters

The views above are published solely for information purposed and are not to be construed as a solicitation or an offer to buy or sell any securities, or related financial instruments. It does not constitute a personal recommendation as defined by the Financial Conduct Authority (“FCA”) or take into account the particular investment objectives, financial situations or needs of individual investors. The views above are based on public information and sources considered reliable.