Warnings of a potential bloodbath in bonds

There is a big disconnect between the US Federal Reserve and the international bond markets. It is a disconnect that could lead to one of the biggest sell-offs in bonds for a long time. Some fund managers even say 2015 might be like 1994 all over again, when the government bond markets crashed as the Fed aggressively raised interest rates.

Wesley Sparks, the head of US fixed income at Schroders, the UK fund house, says he has never seen such a big divergence between US central bank projections for interest rate rises, as laid out in the so-called dot plot chart that shows where voting members of the Fed think benchmark rates will be at the end of upcoming years, and the forecast of the market, expressed in Fed fund futures.

US central bank policy makers expect the main Fed funds rate to rise from near zero today to 1.25 per cent by the end of next year, with the first rate rise pencilled in for next June. The market projects rates to end 2015 at 0.50 per cent, with the first rate rise in October.

By the end of 2016, the Fed’s policy makers forecast rates at 2.75 per cent, while the market has them at 1.50 per cent. By the end of 2017, Fed policy makers expect rates to be 3.75 per cent compared with market forecasts of 2.0 per cent.

Bill Eigen, head of absolute return fixed income at JPMorgan Asset Management, warns of a potential bloodbath in bonds next year should the market continue ignoring the warnings of aggressive rate rises that the Fed has clearly signalled in its dot plot charts.

Of course, his worries might prove unfounded. The 32-year bull run in bonds may keep powering on as it has this year, despite dire warnings of a big correction in the market at the start of 2014 from almost every large fund manager and analyst on Wall Street and in the City of London.

It has to be pointed out that the likelihood of full-blown quantitative easing in Europe (which is expected early next year), the benign global inflation outlook and continuing sluggish growth in many industrialised economies suggest that bond yields, which have an inverse relationship with prices, might remain low in 2015.

But in the US, there has to be risks that yields will rise sharply, should the Fed stick to its forecasts and start tightening policy aggressively in the middle of next year.

With yields on 10-year US Treasuries close to all-time lows and nearly a percentage point lower than they were when the year began, yields surely have only one direction to go — and that is up. If US yields do head north, then yields in other government bonds are likely to follow, despite benign inflationary pressures and the launch of QE by the European Central Bank.

It means 2015 could be a tricky year for fixed income fund managers, particularly those running long-only portfolios. This might explain why absolute return funds have become more popular, as these funds can short the market and use derivatives to protect capital in the event of a blow-up in bonds.

For example, some absolute return funds have bought emerging market credit default swaps to protect portfolios against a sharp jump in yields. Mr Eigen has as much as 60 per cent of cash in his flagship fund, which he will only put to work once the bond market corrects.

It is a mug’s game trying to predict markets, as the spectacular failure of most bond forecasts this year proved. But with Fed policy makers and the markets so badly out of sync over the path of rates, there has to be a possibility that the bond markets in 2015 will experience a similar collapse to 1994, when yields nearly doubled in value.

(Copyright The Financial Times 2014)