The ‘no brainer’ trade was for interest rates in developed markets to rise this year. The rationale cited Fed tapering, economic recovery, rotation out of bonds and into stocks amongst many reasons for higher interest rates. Instead, interest rates have fallen in 2014 and the bond markets are outperforming stocks. The ‘no brainer’ trade is a very crowded trade, so how long can they hold out and what is likely to happen if nerves set in?
The key to understanding why interest rates are falling is to analyse security pricing in its component parts. All risky assets are priced off the cash rate plus a risk premium. Cash rates are zero or at historical lows in most developed markets. Risk premia, for their part, have been trading at well above their long-run averages. For instance, the long run yield premium of US 10yr bonds over cash is about 1.37% compared with 2.65% today and 3.15% at the beginning of 2014. One reason risk premia have been so high is the perception that cash rates were artificially low – that is, the risk of higher cash rates had already been impounded into asset prices in order to induce investors to hold them.
So why are interest rates falling? The simple answer is that cash rates look like being low for a long time. In Europe and Japan, the policy view is that more QE rather than less is needed. In the US, there is no compelling reason to raise the cash rate unless and until inflation spikes up – which is a long shot especially with the breakdown in the monetary transmission mechanism into goods prices. So with cash rates low for good reason, the risk premium on offer in the risky asset markets looks quite attractive. Credit, country and maturity assets have all been bid up strongly over the last 4-6 months.
Who has been buying these securities? Judging by the participation in country bond auctions, the Asian and Middle Eastern sovereign funds have been soaking up fixed income assets across the curve, while corporate bonds have attracted retail investors taking profits on their equity positions.
Who is short and caught? Judging by their performance, the ‘no brainer’ investors seem to be the traditional institutional investors and the Macro Hedge Fund community. Both focus on the short-term. If the lower-for-longer cash rate view takes hold with these investors then they may quickly reverse and the markets could witness another mini 2009-like scramble to get neutral.
Being long fixed income assets feels a pretty comfortable place to be.