Thursday, June 6, 2013

Is The Bond Selloff For Real?

Sam Jones of the Financial Times reports, Quant hedge funds hit by US bonds sell-off:
Some of the world’s biggest quant hedge funds have suffered steep losses in the past two weeks following the sell-off in global bond markets.

So-called “CTAs”, which use computer models to automatically spot and ride market trends, were caught out as investors anticipated an end to the Federal Reserve’s measures to stimulate the US economy, triggering a global rout in fixed income investments.

Bond yields have risen sharply from some of their lowest levels in decades in the past fortnight, leaving funds with large holdings badly hit. Many quant funds have been major buyers of bonds over the past few years as their algorithms have followed yields lower.

“Since mid-May it has been a perfect storm of some of the biggest trends in markets reversing all at once,” said a senior manager at one large quant fund. “It has been particularly brutal.”

AHL, the $16.4bn flagship fund of Man Group, the world’s second-largest hedge fund by assets, lost more than 11 per cent of its net asset value in the past two weeks alone as a result of its huge bond holdings, according to an investor.

News of the fund’s difficulties triggered a 15 per cent drop in Man’s share price on Wednesday.

Aspect Capital, another large European CTA, lost 6.4 per cent in May.

Geneva-based BlueTrend, the $14bn quant division of BlueCrest Capital run by Leda Braga, told investors its fund was down 4.4 per cent for the month as of May 24. The fund has yet to reveal losses incurred last week, but investors say they are likely to be high. BlueTrend runs a more volatile version of the same strategy as Man.

Sources at the funds say this week has also been painful and losses have been extended.

Most quant funds only privately communicate performance data with their investors on a weekly – or even monthly – basis.

Many of them have also had long positions on contracts linked to Japanese equities. The Nikkei has slumped 5.5 per cent so far this week, extending a month-long fall.

“May has rattled investors with large bond portfolios,” said Anthony Lawler, portfolio manager for hedge fund investor GAM. “Across all [hedge fund] strategies, trades that caused pain included long fixed income positions and long exposures to the many markets that reversed or were choppy, including energy, Japanese equities and soft commodities.”

Although CTAs are known to be volatile, the losses are still among the highest reported to investors in years – and have been spread broadly.

Graham Capital, the US’s largest CTA, was down 3.9 per cent for the month, while Holland-based Transtrend was down 3.1 per cent.

Winton, the world’s largest quant fund, managed to sidestep the worst of the losses. The London-based company dropped just 2.5 per cent in May, but is still up 6.5 per cent for the year.

Although almost all of Winton’s losses were attributable to US bond market moves, unlike its peers, Winton has moved to diversify its algorithmic trading programmes into cash equities and away from its traditional focus on futures contracts. The fund also operates with lower leverage than many of its rivals.
The selloff in U.S. Treasury bonds hammered CTAs in the last couple of weeks as bonds suffered the fourth-worst month in 20 years:
Concerns over a potential end to US quantitative easing saw global fixed income markets slump in May, but further sudden sell-offs may be less likely.

The Bank of America Merrill Lynch Global Bond Market Index fell 1.5% last month, its largest loss since April 2004, with 'safe haven' sovereign debt particularly affected.

In the US, investors beginning to position for an eventual 'tapering' of quantitative easing pushed yields on 10-year treasuries from around 1.7% to as high as 2.2%, with benchmark debt losing 3.3% over the month as a whole.

The UK market saw 10-year gilts shed 2.3% in sterling terms last month, as expectations of further QE in the near future declined, while concerns over 'Abenomics' saw Japanese 10-year yields rise from 0.3% to 1% on the month.

According to J.P. Morgan analysts, the only 'materially' worse months for the global bond market in the past two decades were February 1994, when the Federal Reserve surprised investors by raising rates, and the fallout from the 'VaR shock' seen in Japan in July 2003.

Those analysts also noted that bond ETFs in the US saw their largest weekly outflow on record last week, at $1.5bn, but they are skeptical over the prospect of a further sell-off.

"We estimate that a rise of 100bp in yields [from early 2013] would be required to prompt material selling of bond mutual funds. The 30bp rise in yields over the past month, coming on the back of a previously solid YTD rally, still falls some way from meeting that mechanical threshold.

"Bond positions are likely not supportive of a further sell-off."

Barclays' global macro team also said investors may be getting ahead of themselves in anticipating Fed tightening, though they suggest May 2013 may eventually come to be seen as an "inflection point" in the present era.

"Even in the US, which seems likely to lead the way toward normal monetary conditions, there is at the moment almost no reason to fear that the monetary authorities will feel under pressure to act soon, or abruptly," the team said.

However, given current correlations between global bond markets', Barclays notes the "worrisome" potential for contagion from an eventual tightening in the US meaning "tighter financial conditions in regions less prepared for it".

Expectations of such moves have been brought forward in recent weeks. The 'tapering off' of the Fed's QE programme, while conditional on further improvements in the unemployment rate, is now expected to commence towards the end of this year.

CME futures contracts, meanwhile, suggest almost one in three investors now expect a fully-fledged rate hike in the US by mid-2014.
The question now is whether this selloff is for real or just another fake breakout before yields settle back down below 2%. Business Insider reports that Goldman Sachs recently declared that the selloff in Treasury bonds is for real:
They're convinced bond prices are heading lower, which means interest rates are heading higher.

"Our bond valuation models (Sudoku and GS Curve) and a separate study of the determinants of US Treasury yields which explicitly accounts for the impact of QE, policy ‘guidance’, uncertainty and the European crisis indicate that intermediate yields should be trading in the upper half of this range, given the decline in systemic risks and the brightening US economic outlook," wrote Goldman's Francesco Garzarelli and Silvia Ardagna in their note. "Our model estimates (and, consistently, our forecasts) show 10-year Treasuries reaching 2.5% in the second half of this year, with German Bunds trading at 1.75%."

Garzarelli spoke with the WSJ's Katie Martin about the call (see below).

He noted that interest rates won't rise straight up, but that there would be "speed bumps" along the way. This is why Goldman recently told clients to take some profits on their short positions.

Nevertheless, Garzarelli continues to be convinced that rates are heading higher.
With inflation expectations falling to a 10-month low before Friday's U.S. jobs report, it's growth, not inflation, driving bond yields. Importantly, global economic activity picked up steam in May after output rose from both services and manufacturing firms, a business survey showed on Wednesday:
The Global Total Output Index, produced by JPMorgan with research and supply management organisations, rose to 53.1 in May from 51.9, spending its 46th month above the 50 mark that divides growth from contraction.

The PMI was lifted by increased output in the United States, Japan, Britain and India but the euro zone remained in a protracted downturn, JPMorgan said.

New business came in at the fastest pace since February, leading to rising employment levels.

A Global Services Index rose to a five-month high of 53.7 last month from 52.1.

Activity in the vast U.S. services sector picked up slightly in May, though growth was still lackluster and a measure of employment fell to its lowest level in close to a year, an Institute for Supply Management report showed.

Europe's economic woes eased slightly last month, helped by a surge in British services business and signs the downturn in the euro zone is starting to ease, earlier surveys showed.

Global manufacturing only grew marginally last month but with new orders coming in at a faster pace than in April, conditions should improve, a sister survey showed on Monday.

The index combines survey data from countries including the United States, Japan, Germany, France, Britain, China and Russia.
If global growth is picking up in most regions, including Europe which remains weak, then you would expect bond yields to rise even if inflation expectations remain subdued. As discussed earlier this week, Abenomics might succeed in lifting inflation expectations in Japan but it will export deflation to the rest of the world

In fact, the rising U.S. dollar is extending the slump in commodities and hitting commodity currencies hard. The Australian dollar continued its dramatic slide on Thursday, hitting a 20-month low against the U.S. dollar below the 95 cent mark to levels unseen since October 2011. So far, the Canadian dollar is holding its ground despite weakness in the usually closely aligned Australian dollar after some weaker-than-expected growth data in that country. That could change after Friday's release of U.S. and Canadian employment data.

All this suggests that a lot is riding on Friday's U.S. jobs report and the market's reaction could be a harbinger of things to come in the second half of the year. If the bond selloff is for real, it might be an ugly summer for global bond and equity markets, especially if yields start rising at an alarming rate. If it's a steady rise due to a pickup in global growth and inflation expectations remain subdued, cyclicals will continue to outperform defensive sectors.

Below, the WSJ reports that Treasury bonds fell a long way in May and now the rise in yields has run out of steam. But Goldman Sachs’s Francesco Garzarelli says it’s just a pause for breath. He tells Katie Martin that the rise in yields will not be a straight line.