It is interesting to note how extreme the consensus view was on the outlook for bonds at the start of this year, when just about all the major investment banks were recommending overweighting equities versus fixed income.
In addition, bond fund managers were on average holding very short duration.
The year-to-date performance of bond markets has been positive, however, serving as a reminder that consensus expectations may not always be right.
Back in June last year, the fund held ultra-low duration of just over one year, but after the sell-off that followed, this was increased to its present level of around four years. So I am not as bearish as I was, although this duration position is still short relative to a neutral stance for the fund.
I have in particular added interest rate risk in Europe to the portfolio, as the prospect of deflation in the eurozone has increasingly become a concern. Growth is stronger in the US and UK, but I expect the Federal Reserve and the Bank of England will continue to give the recovery the benefit of doubt and leave interest rates unchanged in 2014.
In the longer term, the market appears to be pricing in the 10-year US Treasury yield rising to about 4 per cent in 10 years’ time, matching the median expectations among the Federal Open Market Committee members.
This suggests that we are a long way through the correction that began last summer, being much closer to fair value. Against this backdrop, I have looked to add duration when government bond yields have risen over 3 per cent and sell duration when they have fallen below 2.5 per cent.
Should the Fed raise rates, I would expect the emergence of worrying signals on inflation. Currently, however, the Personal Consumption Expenditure measure of prices, also known as the Core PCE Deflator and the Fed’s preferred indicator, remains around 1 per cent, below its target level of 2 per cent.
This low inflation environment, which has been partly driven by wage growth stagnation, should make the Fed unlikely to respond to lower unemployment and growth in gross domestic product with higher interest rates.
Although headline employment data has been improving, it should be remembered that the participation rate has fallen, which opens up the question of what spare capacity there is in the economy.
This could mean there is still a way to go before we see enough upward pressure on wages to feed through to inflation.
So, while I expect the Fed to continue tapering quantitative easing and eliminate this activity by the end of this year, interest rate rises are likely to be further away than that.
Looking at the eurozone, the risk of deflation has become an increasing concern, and the market may have started pricing this possibility into bond valuations.
For example, five-year Irish government bond yields have dropped below US Treasuries and gilts, helped by Ireland’s positive economic reforms and spending cuts. But its falling yields also partly reflect the prospect of deflation, which might have replaced creditworthiness and default risk as the main worry in the region’s periphery.
In terms of a possible policy response from the European Central Bank, a QE programme like that undertaken in the US or Japan appears unlikely. ECB President Mario Draghi confirmed at the World Economic Forum in January that the legality of this activity in the EU has been brought into question. I would therefore expect to see another interest rate cut or renewed action to stimulate lending by the ECB similar to its previous long-term refinancing operations.
Within the M&G Global Macro Bond fund, sensitivity to European interest rate risk has recently been increased, mainly through increasing its exposure to German government bonds, which I felt looked better value relative to US Treasuries.
With selective reductions to the latter, the fund’s overall duration has remained slightly over a year short of its neutral position, although the duration contribution from European assets is now overweight relative to a neutral stance.
Euro-denominated assets currently account for 1.4 years of the fund’s duration, while most of its other interest rate risk continues to stem from US dollar- and sterling-denominated bonds, respectively contributing around 1.8 years and 0.7 years. A small remainder is derived from holdings of Swedish, Norwegian and Mexican government bonds.
Jim Leaviss, manager of the M&G Global Macro Bond fund