Are Gilts in a Bear Market
To understand this breakdown in correlation we need look no further than the source of the risk: the answer, just like in May 2013 when Bernanke gave us his taper tantrum, lies in rising rates. I am sure everyone will remember this period, as the price action was fairly brutal and also widespread. This time, in our opinion, it will likely not be so brutal, which means it may not reach to all asset classes, although the headline sectors of rates, credit and equities are all being affected currently.
The reason we think the price action will remain controlled is that the market is in a far better place today than it was almost five years ago. The world is enjoying its best period of growth since the global financial crisis and that growth is set to remain in situ throughout 2018 and 2019, unlike in 2013, when the fear of recession was always just around the corner. Technicals remain strong with the big four central banks holding over $15 trillion of low risk assets, with the result being too much cash on the sidelines leaving investors looking to buy dips, meaning that these dips have been shallow and short lived.
So what prompted this move up in rates and is it justified or is it going to reverse?
It was likely triggered by a combination of inflation fears, a change in the order at the Fed, and a heavy supply. Net issuance in 2018 of Treasuries and T-bills is forecast to be more than double what we had in 2017, and remember, in 2018 the impact of Fed buying will be small. The upshot of this so far is that we have seen almost 40 basis points added to the 10 year yield. Today’s levels are approximately where we thought they would go to by year end, but in the light of some of the new events, we think rates are likely to finish higher still, meaning steering clear of longer dated rates products is still the right thing to do.
So the move in rates is justified, but the move in both credit and equities is based on fear and valuations rather than fundamentals or technicals, so in all likelihood, this move should reverse as investors once again seek to buy the dip. Timing of course is tricky, as most investors fear that 2018 will see an intra-cycle correction, so the question to ask ourselves is; is this it? At this stage, while the moves in rates are quite material, the moves in credit and equities are still quite small. So this is not the correction that many were expecting (yet), but it’s a healthy booking of profits nevertheless. Watching how the current breakdown in correlations materialises will tell us if this is profit taking or a slightly bigger move.
As far as we are concerned, we will be waiting for better entry points before adding more risk.