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Our views 14 June 2021

JP’s Journal: Market rationality

5 min read

There are certain weeks where you feel that you are not in tune with things. Last week was one of them.

The US CPI print, at 5%, was eye catching and US treasuries sold off in the aftermath with 10-year yields hitting 1.53%. Five hours later yields were lower than the start of the day, hovering around 1.43%.

At that level treasury yields are back to where they were in late February, despite inflation expectations being markedly higher. If you look at implied inflation in February it was about 2.1% at the 10-year horizon – now it is around 2.4%. Another way of looking at this is that real yields have continued to fall.

There are three possible explanations for the move lower in yields:

  1. investors are complacent about the inflation threat
  2. investors correctly perceive inflation to be transitory
  3. investors are positioned for higher yields and there was short covering when the immediate rise in yields was not sustained.

Across our strategies we have pared back duration over the week – not by much but that is the direction of travel. Whilst we do think inflation will come down later in the year, I don’t think risks are fully reflected in current valuations.

Two things have recently caught my attention that has caused me to question whether financial markets are servicing economies well. One was a bond issue from Microstrategy, a US-based provider of enterprise software that generates business insights through collecting data from existing enterprise applications. The company is of relatively small size, with USD 481mn in revenues and about USD 80mn of EBITDA in 2020. Last week it issued USD 500mn of senior secured notes to buy Bitcoins, this being in addition to debt issued In Dec 2020 and Feb 2021. Frankly, I don’t know whether Bitcoin is a good or bad investment, but RLAM will not be buying fixed rate debt issued to finance Bitcoin purchases despite its Moody’s rating of Ba3. We stick to our view that credit ratings don’t tell you everything.

The other was work by researchers at Oxford University who have created a machine-learning programme that can project how share prices move over very short periods of time – by using principles from natural-language processing to trawl liquidity data across limit order books. For some strategies this may be revolutionary – hedge funds with time horizons measured in hours and days for example. But does it really help financial markets? The more we see financial assets as short- term punts rather than trying to allocate capital for longer term benefits the more financial markets will be seen as a casino – and in the long term that is a bad outcome. As credit investors we see ourselves as lenders rather than traders.

Cash, government bonds and currencies

No real change in currency markets over the week with sterling staying towards its recent highs. Cash rates remained low with little movement in most markets. Despite inflation data there was no significant change in implied inflation – although these remained towards the highs for the year in all markets.

The higher US CPI data was interpreted as “transitory”, reflecting the gains seen in sectors related to transportation which were particularly hit in the crisis period; in addition price spikes were seen in areas hit by shortage related problems, including airfares, used cars and car and truck rentals. However, some core components such as shelter recorded large moves up. The Fed will be watching the labour market data closely to see whether wage growth starts to pick up and unemployment decline.

The ECB raised its growth forecast for 2021 euro area growth to above 4.5% but expects inflation to be subdued. Whilst the ECB was more optimistic on the outlook for activity, they don’t expect the short-term increase in CPI to last.

Credit

The current background of falling real yields remains supportive of credit markets. Over the week high yield indices recorded new highs – meaning that the cost of finance for the riskier credits has never been lower. It remains the case that, despite the 2020 output shock, the incidence of defaults remains low and this is unlikely to change unless there is another leg down in activity or rates start to rise.

What this means is that the credit spread premium remains attractive and constitutes a significant part of the overall yield in credit markets. Investors are getting paid well to take credit risk. This is especially the case, although it goes against the consensus, for BBB and BB rated issues. Here credit spreads remain significantly above what is required to compensate for historical default rates.


Past performance is not a reliable indicator of future results. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are the author’s own and do not constitute investment advice.