Navigating Fixed Income markets
The substantial rally in US treasury bonds in August is a paradox, being both completely understandable, yet somehow illogical. The catalyst for the rally in US, and indeed Australian government bonds over the last few weeks is well known and documented, but can be summarised as a “flight to quality” with the move in US treasuries paralleling the upward propulsion in the gold price and inversely correlated to the performance of both equities and credit (more on the “quality” bit later). Yet the root cause of the crisis is debt and the fact that there’s too much of it. And, wasn’t it the debilitating debate over the US debt ceiling that kicked the bond rally off in the first place?
A more fundamental explanation of recent market developments is a pronounced downgrading of global growth expectations reflecting both a reassessment of the recession risk in the US economy coupled with anticipation that such a move would spur Bernanke and the US Federal Reserve back into action with QE3, together with growing concern about the European banking system. The Fed’s initial move was to declare that the Federal Funds rate would remain anchored at effectively 0% for the next 2 years, giving it time to evaluate what further steps, if any, it could take. The market’s current favourite (out of a relatively limited armoury) involves the Fed extending the duration of its balance sheet by selling the front end of the yield curve and buying longer dated bonds. European policy makers have found a substantive response much harder to come by, which has left markets unsatisfied.
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