Harbour Monthly Commentary: Bond Market Blues

• The bond market sell-off that started in May, continued in June, as the US Federal Reserve upgraded their economic outlook and outlined a possible timeframe for easing back on QE (Quantitative Easing).
•  Long-term bond yields rose, with NZ and US 10 year yields rising 35bps and 56bps respectively. NZ 10 year yields have risen 96bps in two months. The market move was characterised by high volatility and poor liquidity, as investors rushed to abandon the ‘carry trades’ that were reliant on ongoing low cash rates.
•  Returns for long duration assets were the worst. The ANZ NZ Government Stock Index rolling 12 month return fell to just 0.03%, while the ANZ Corporate A-Grade Index return was 4.49% over the same period.
•  A new mindset towards fixed interest looks to be in play. The previous focus on searching for yield and income looks to have been replaced by an aversion to interest rate sensitive assets. As the US and NZ economies steadily improve, further rises in bond yields seem likely.
•  The RBNZ remains steadfastly on hold, despite surging confidence, the strong housing market, increased activity in Canterbury and a lower NZ Dollar.

Ever since QE was first launched in the aftermath of the GFC, central banks and investors have been pondering exit strategies and how markets and economies might manage through this phase. During May and now June, we have had a taste of that. So far, it has not been all that different to previous turning points in market trends. The biggest surprise has been that the Fed has led the way.

Throughout the years of extraordinary policy measures, the Fed has emphasized that it will take it's time over removal of stimulus. The tone was reinforced by the Evan’s Rule initiative , whereby the Fed stated they would maintain a loose policy stance as long as the unemployment rate remains above 6.5% and inflation is below 2.5%. These preconditions have not yet been met and indeed the Fed do not expect to be hiking the Fed Funds Rate within the next 12 months.

However, while the Fed Funds rate will not change for some time, QE may be eased back. (‘Tapered’ is the Fed’s chosen adjective.) In June the Fed followed up hints made in May by saying that the FOMC “may moderate purchases later in 2013” if the economy continues to improve as expected. The market was surprised by both the Fed’s confidence in the economy as well as the more specific indication that QE bond purchases would be reduced.