If you haven’t heard mention of it in the news, or read about it in the papers or your portfolio manager’s commentary, there’s an election coming up in Germany. It’s important too! The outcome of this election has implications well beyond Germany, and well beyond Europe. In this post, we’ll look over the basics of the election, so that you’ll know how to make sense of the results when they come later this month.
First, why is this election so important? There are a couple of main reasons. Germany is one of the main centres of gravity for the European Union. Their export-driven economy is the engine driving a nascent EU recovery, and Germany’s ability to continue churning out that growth is highly interrelated with the domestic policy agenda of the government. Secondly, Germany’s one of the big wheels in the EU and almost nothing gets done without its approval. Read more
Let me set the stage. The price of oil is up over 7.5% in the past month. We’re looking at the beginning of the end of quantitative easing in the United States and the consequent rise of interest rates. Escalating mortgage rates could frighten potential homeowners back into renting. We have a raging (as well as politicized) debate as to who should be our next Fed chair. Financial markets and currencies from many emerging economies are hitting the wall. The U.S. government is about to enter a protracted debt-ceiling debate. And, as if this is not enough, we now have a possible U.S. intervention in the Mideast that could rattle worldwide financial markets. The winds of war may breach any national border.
With this backdrop in mind, the question we must pose is this:
Setting aside the moral, ethical, and political conundrums of a U.S. intervention in Syria, how should we expect financial markets to react when conflict in the Mideast flares up? Read more
In a perfect world, a diversified portfolio would have asset classes that are uncorrelated, allowing an investor to maximize return while minimizing risk. As every high yield portfolio manager has probably told you, high yield bonds have had low correlations with other asset classes, and they can offer attractive risk-adjusted returns. This low level of correlation has allowed investors to benefit from allocating to high yield bonds. According to Barclays, monthly high yield bond-return correlations have been negative versus U.S. Treasurys over the past twenty years. Obviously, that correlation statistic includes a time period of declining Treasury rates.
So what have correlations done during the most recent increase in rates?
Despite what feels like a 1.00 (perfectly positive) correlation to rates, high yield bond daily-return correlations to the Barclays U.S. Treasury 5-7 Year Index since May 1 are elevated, but still remain relatively low, only 0.20 (unless otherwise noted, all performance information is as of August 27, 2013). Read more
For those involved in trading the fixed income markets, August is usually one of the more mundane months. Issuance of new corporate debt slows down significantly since many global investment professionals are on vacation, forced two-week leaves, or holidays, which results in liquidity that is much more challenging. But unlike past years, we’re entering into a September time frame that is poised to be anything but boring, thus causing a likely increase in volatility. So just like the coming attractions at your local movie theater, this is what we have to look forward to in the month of September:
Specific events and their release date:
- “The Last Picture Show” (September 6) – On this Friday, the final major piece of the employment puzzle, the August non-farm payrolls, will be released to the market. This will either confirm the prevailing wisdom regarding the underlying strength of the U.S. economy and the likelihood of tapering of the Fed’s quantitative easing program, or it will provide a difficult conflicting perspective only days before the FOMC meeting. Read more
Mark Carney has really put his stamp of authority on the Bank of England (BoE). After just one month as the BoE’s new governor, he’s already shaking things up. At the latest meeting of the Monetary Policy Committee (MPC), he introduced forward guidance that would have been almost unimaginable under the previous Governor, Mervyn King.
Here’s what Carney’s forward guidance looks like. The MPC intends not to raise their benchmark bank rate from its current level of 0.5% until the unemployment rate falls to a threshold level of 7%. This is subject to three caveats:
- inflation is no higher than 0.5% above the 2% inflation target at the 18-24 month horizon
- medium-term inflation expectations are contained
- and the Financial Policy Committee (FPC) believes that an accommodative monetary policy stance doesn’t pose a risk to financial stability. Read more
We can give three simple reasons to support the use of volatility products to hedge tail risk in fixed income portfolios. First, equity volatility and bond prices have a strong conceptual link. If you think of a corporate bond as functionally equivalent to a risk-free asset (like a Treasury bond) plus a short put option on the issuer’s assets, then the additional yield you receive above the Treasury rate (a.k.a., credit spread) can be thought of as compensation for the sale of that put option. When equity market volatility jumps drastically (as it does during a tail-risk event), the implicit liability from the short put position increases in probability. In a nutshell, the value of bonds will fall as market volatility (yes, even equity market volatility) rises. Read more