In a recent piece, we speculated that the UK was heading for a steeper gilt curve. In the couple of weeks since then, we have seen that hypothesis transpire, but we have also begun to see its reversal, as markets swing violently in August.
Over the past week, demand has been strong for longer-dated gilts, driven by a global grab for yield and duration. This has forced many investors out of their curve steepening positions. The crowded nature of the steepening trade, exacerbated by the thin liquidity of the summer months, resulted in the unwinding being particularly aggressive.
Valuations have moved to extreme levels. In the UK, all gilt yields have fallen below 1% for the first time in history. Similarly in the US, 30-year treasuries dipped below 2% to their lowest ever levels. More extreme still, the entire German bund yield curve has slipped into negative territory.
Fear lies at the root of these unprecedented market conditions. The ongoing difficulties for the trade talks between the US and China have provoked fears that the global economy might be heading towards recession. Meanwhile the likelihood of a ‘no-deal’ Brexit appears to have risen, elevating the probability that the Bank of England might be forced to cut interest rates.
The UK and US yield curves both inverted last week, meaning that longer-term interest rates fell below shorter-term rates. While yield curves tend to invert ahead of recessions, there has historically been a long and variable lag time of 10 to 30 months. Highlighting the level of panic in markets, the Dow Jones Industrial Average reacted by plummeting 800 points (3%).
Due to the low volume and volatile seasonality that arises in summer months we have been running lower risk than normal within our portfolios. Our conviction levels have remained low, given the relentless uncertainties surrounding the US-China trade talks and the Brexit drama showing few signs of abating.
Nevertheless, we are beginning to gradually increase risk, believing that we are nearing an end-game to this current bond rally. It seems fairly clear that markets have become blinded by bearish sentiment, and the funding of negative yielding zero coupon issuance is unsustainable. At some point investors will realise the Emperor has no clothes on!
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. The views expressed are the author’s own and do not constitute investment advice. Portfolio holdings are subject to change, for information only and are not investment recommendations.