Investors have begun to accept the fact that tighter monetary policies are endangering economic growth.
Investors are dumping long-dated bonds to cover themselves, and yield curves have been inverted from Germany to UK for the first time in decades. The euro’s worst week since may and the pound’s fall was due to fears that the Bank of England could trigger a contraction. Traders fled to the safety and stability of the dollar.
The shift in focus was sealed by a swathe weak economic data , from Germany and France. This followed the UK’s shocking inflation report and the surprise half-point increase of interest rates.
The focus now shifts to the main conference of the European Central Bank in Sintra (Portugal). Traders are going to parse out the latest mutterings of the ECB’s top officials, the Federal Reserve, Bank of England, and others, in order to get a sense of how much they want borrowers squeezed. Also, the latest inflation figures for the eurozone and German Ifo will be key. The data this week have given the recession argument a solid footing and I expect that to continue, said Gordon Shannon. Portfolio manager at Twentyfour Asset Management LLP.
Bond Markets flash warnings across the region.
Investors demand higher yields for holding longer-maturity bonds compared to those with shorter maturities. In fact, the near-term rate is higher than normal, which implies that market expectations are for rate increases followed by cuts if the economy stagnates.
German 2-year bonds yield over 70 basis points higher than comparable 10-year securities. This is the highest since 1992. In the UK it is over 80 basis points. This is the highest since 2000.
In this environment, longer-maturity Euro area bonds have been favored, with returns of 3,8% this year, which is more than eight times that of their shorter counterparts.
Shannon, a Twentyfour analyst, has been positioning herself for a possible recession for several months. She gravitates towards high-quality credits, but also holds some longer-dated UK Government Bonds.
Shannon stated that “Gilt Yields are already high and have more of a potential to rally due to recession fears than Bunds or US Treasuries.”
The prospect of negative growth may spell trouble for sterling.
The UK currency has performed better than its G-10 counterparts so far this season on the belief that higher interest rates will enhance the appeal of UK assets. The BOE’s rate hike and this week’s grim inflation report could lead investors to focus on economic fundamentals rather than the high potential returns.
Investment strategist Guillermo Felices at PGIM Limited said: “I expect the risky asset market to begin putting greater weight on the negative implications of tighter monetary policies for growth.”
He said, “That means downwards pressure on GBP despite higher rates of interest.”
Options traders have already begun to show signs of this, turning the most bearish in almost five months.
As the possibility of recession increases the selling of higher yielding currencies such as the pound those seen as a refuge stand to benefit.
In times of uncertainty, the low-yielding status of the Japanese yen, which has been punishing it for all year, turns into a “safe haven” feature.
Van Luu sees 55% chance of global recession within the next 12-18 months.
He said that the global growth cycle was not improving, but rather worsening. In this scenario, the yen is a good defensive currency.
The dollar is expected to be the largest winner. It’s widely considered the safest currency in the world. Investors have already started buying the dollar, which has helped the Bloomberg Dollar Spot Index end a three-week loss streak.
Fredrik Repton is a senior portfolio manager at Neuberger-Berman for global fixed incomes and currencies.
Repton increased his long dollar position against the euro in anticipation of the weak European pmi readings on Friday. He bet that the data will amplify the recessionary fears within the euro zone and the divergent outlook for growth across the Atlantic.
He said that the US dollar was seen as a protective asset class, and also offered an attractive carry-over.