Fund Selector: Bond volatility heightens

The then US Federal Reserve chairman, Ben Bernanke, triggered abrupt weakness in bonds – and equities – by suggesting the central bank might reduce its bond-purchase programme.

We are now amid another period of heightened bond market volatility, illustrated by the biggest four-week sell-off in German bunds in more than 20 years.

One of the key characteristics of the 2013 experience was that the bond market rout completely preceded the central bank’s tapering activity. The reduction in its bond purchases began in December 2013 and yet US government bonds were able to enjoy exceptional returns in 2014, particularly in the first half of the year.

City Financial has spoken to a number of fund managers who think that an interest rate rise in 2015 will be met with similar indifference, as government bond markets have already repriced significantly from their yield lows in late March and early April.

However, we feel this may be an overly simplistic assessment of the situation. Bond volatility has indeed been elevated in recent months and is comparable – or higher – with the 2013 experience.

This reflects the unsettled environment in a year of US monetary policy uncertainty. Ten-year US government bond yields have swung sharply and unpredictably during the past nine months, but broadly within a relatively defined range between 1.6 and 2.5 per cent.

The move from the most recent trough in April of 1.86 per cent to the most recent peak in the first half of June at 2.48 per cent is material, but is dwarfed by the 2013 experience when yields almost doubled to 3 per cent. There is certainly potential for more pronounced weakness around key changes in monetary policy.

Although we fully acknowledge the structural headwinds to sustain above-trend economic growth, we also think the Federal Reserve is very mindful of the inflation risks from a gradual recovery in the price of oil and a tightening labour market with limited improvement in productivity.

Key policymakers have clearly indicated a preference for raising the interest rate this year and the recent improvement in economic data may support such a move.

Yet in spite of the recent bond sell-off and the message from the Federal Reserve’s last dot plot forecasts in March, this is far from fully priced into the markets.

June’s dot plot revisions will be a crucial determinant of the short-term pricing environment, but we anticipate significant further risks to government bonds in the event of an interest rate rise. The recent episode may well prove a precursor to the dislocation and illiquidity around changing central bank policy.

Our proprietary risk models, which correctly anticipated the expansion in bond volatility from late 2014, are certainly warning that risks remain high in the short term.

Opportunities still exist in the short term, but fund managers with a sanguine outlook for fixed income may well be disappointed. Risk is being blindsided by increasing volatility across a growing range of asset classes as the year progresses.

Mark Harris is head of multi-asset at City Financial