Volatility continues to characterize fixed income markets amid forecasts of sluggish economic growth and signs that large banks may be less resilient than previously thought to another financial crisis.
“The market had gotten pretty complacent over the past year with credit spread volatility reaching 10 year lows” Jesse Fogarty, managing director at Cutwater Asset Management, told Markets Media. “The market reached a breaking point when the global slowdown became more apparent in early October, specifically the inability of Europe to jumpstart their economy and their dangerously low rate of inflation.”
Fogarty will be speaking at Markets Media’s Global Markets Summit New York on November 20.
The International Monetary Fund projected last month that the world’s economy will grow 3.8 percent next year, compared with a July forecast for 4 percent, after a 3.3 percent expansion this year, triggering a rush toward U.S. Treasuries.
“October witnessed periods of illiquidity which was particularly evident in the high yield space where selling was most pronounced,” said Fogarty. “You saw some pretty exaggerated moves in the market subsequent to the IMF meetings after there had been some revisions to global growth."
Jesse Fogarty
Cutwater Asset Management
The lack of liquidity was not limited to the corporate credit markets but spilled over into the U.S. rate markets, the most liquid fixed income market in the world. "On October 15, the Treasury market had its own version of a flash crash with the market swinging over 6 points in a day on the long bond,” said Fogarty.
Weakness in the resilience of the banking sector was highlighted by the results of stress tests by the European Central Bank (ECB) of the 130 largest banks in the euro area as of 31 December 2013. The tests showed that a severe scenario would deplete the banks’ top-quality, loss-absorbing Common Equity Tier 1 (CET 1) capital—the measure of a bank’s financial strength—by about €263 billion.
The IMF issued a statement that “the exercise provides an important basis for further strengthening bank balance sheets, dealing with weak institutions, and additional lending to support the recovery.”
Cutwater, with $23 billion in assets under management and which employs fixed income strategies such as core, long duration, high yield, loans and absolute return strategies, is in the process of being acquired by BNY Mellon, and will operate and be administered by Insight Investment, a BNY Mellon investment management boutique in Europe.
Cutwater has been reducing its overweight to credit in general. “While still constructive on risk assets the extent of our overweight has come down throughout the year driven by valuations,” Fogarty said. “Spreads grinded tighter through the middle of the summer, reducing the margin of safety which led us to reduce risk and tracking error within our portfolios. Tactically we did add some high yield exposure in in the sell – off where we saw the widening as overdone.”
Liquidity has dried up, especially for high-yield instruments, driven by regulatory changes and a general aversion to risk on the part of banks. “The ability of dealers to take risk has been has been lessened by the regulatory environment, but there’s also less willingness to take that risk,” said Fogarty. “So it has been challenging from that perspective.”
In the United States, growth has been increasing at a moderate pace, and this together with the slow growth forecast for Europe is likely to cause the Federal Reserve to delay raising interest rates.
“The Fed is definitely looking at the global picture and the slowness in Europe, and it is reflected in the fed funds futures market, with the timing of a rate hike getting pushed out,” Fogarty said. “Two or three months ago, you had the possibility of the Fed moving in early ‘15. That has been pushed back to the fall of next year. At the beginning of the year nobody expected the 10 year to be sitting at 2.30 percent.”
Featured image via sergey_p/Dollar Photo Club
