During the taper tantrum in May 2013, US 10-year yields jumped 100 bps over seven weeks, implied volatility in German Bunds doubled and European equities fell 11.4%.
Over April and May this year, US 10-year yields are up 65 bps, Bund volatility has almost trebled and European stocks are 8% off their highs. So, déjà vu all over again, then? We don’t think so, but we do acknowledge that the market narrative—especially in fixed income markets—is entering a new regime.
There are a couple of differences between the recent bout of volatility and the 2013 taper tantrum. First, in terms of market price action, the contagion effect is smaller. Notably, credit markets are better behaved this time; while it is true that credit has started to trade a little “heavy” of late, we believe it can be largely explained by the issuance calendar. Second, in contrast to the taper tantrum, central bankers around the world are at great pains to reiterate that their reaction function has not changed. In the U.S., at least, it appears the market is responding to the turn in data, not to a change in how the Federal Reserve (Fed) reacts to the data.
A favourite sport of many commentators is to play “pin the current move ‘tail’ on the historical analogy ‘donkey’” any time the market enters a bout of volatility. Little wonder that comparisons of current bond market moves to the taper tantrum abound. It’s equally true that “this time is different” is a contender for the most dangerous phrase in finance, so to dismiss historical analogies out of hand would be foolhardy. We prefer instead to focus on a comparison of the underlying drivers of any moves, rather than compare market price action alone.
While there are passing similarities between the recent sell-off in bonds and the taper tantrum, the drivers are quite different. Credit markets and emerging market debt, in particular, suffered a significant drawdown over the taper tantrum, but are holding up quite well through the current move. In part this reflects the less extended positioning, better spread levels and more measured sentiment in the asset classes going into the current rates sell off.
Ahead of the 2013 taper tantrum, US high yield spreads stood at 425 bps and effective yields at 530 bps, rising to 525 bps and 685 bps, respectively, by the end of June 2013. Roll forward to April 2015 and US high yield spreads started the month at 495 bps, with effective yields at 625 bps—notably more attractive on both measures than at the start of the taper tantrum. More importantly, the impact of the slump in energy prices at the end of 2014 had washed out any remaining vestige of exuberance from the asset class. As a result, high yield—and credit markets more generally—took the rout in government bond markets in its stride. However, recent signs of strain in credit are prompting some concerns that the asset class will now succumb to the weakness elsewhere in fixed income.
In our view, the recent modest widening of spreads is amply explained by the heavy issuance schedule we’ve witnessed. Traditionally, May—along with January and September—accounts for a large share of annual issuance. With M&A picking up, debt issuance exceeded even a generously seasonally adjusted average level. The increase in dealer inventories bears out the notion that credit markets are now in a process of digesting recent new issues, and pricing in the secondary market is merely reflecting concessions from primary issues.
Nevertheless, to put things in context, US non-financial investment grade issuance in the three months to May was 70% higher than over the same period last year. Yet US IG spreads have only widened 5 bps in that time frame. During the 2013 taper tantrum, credit spread widening kept pace with the Treasury sell-off almost one-for-one during the initial shock higher in yields. The current price action in credit may be showing signs of “new issue indigestion”, but is some way removed from the disruption of the taper tantrum.
The contagious effect of the taper tantrum across asset classes was, at least in part, likely due to perceived change in the Fed’s reaction function. The central bank position shifted from extraordinary liquidity provision to signalling a path towards normalisation and data dependency, which shook asset markets out of their lazy uptrend for a time. By contrast, recent moves in riskless rates can be attributed to a change in data, rather than a change in narrative.
Fed chair Janet Yellen continues to reinforce the notion of “data dependency”. With inflation bottoming and activity data rebounding, two central themes that pushed bond yields lower in late 2014 and early 2015—the soft patch in growth and the disinflationary impulse from weaker commodities—have run their course. In our view, further upside in bond yields is most likely to result from improving growth data, rather than from inflation. We believe that the very same improving growth data will lead the Fed to begin the process of normalising rates from September—indicating that the Fed’s reaction function has not changed.
When improving growth pushes rates up, we expect to see two effects: higher bond yields led by rising real rates, and relative calm in riskier assets—exactly what we’ve seen with yields sharply higher yet the VIX stable at just 13. Certainly, history would suggest ample scope for some volatility around the first rate rise itself, but absent any change to the Fed’s reaction function, riskier assets should quickly regain their poise from the start of a growth-induced hiking cycle. In turn, this leaves an environment in which government bond yields can continue to reprice higher, while equities and credit provide modest positive returns.
In sum, any supply related weakness in credit is likely to offer a potential opportunity. While riskless rates continue to grind higher in our core scenario, we note that BBB-rated credit spreads, at 280 bps, are 70 bps higher than they were, on average, ahead of the start of the last five rate-hiking phases. With an improving growth picture driving riskless yields higher, this gives ample scope for credit spreads to compress to offset at least the first few increases of the new rate cycle.”
John Bilton is global head of the Multi-Asset Strategy Team at JP Morgan Asset Management