How the pros see the fixed-income market

By Felix Salmon
April 6, 2011

Every year, the Loomis Sayles PR team drags its top fund managers down to New York for lunch with the wonkier end of the financial-journalism spectrum: there’s lots of talk of curve-flatteners in a rising interest-rate environment, that kind of thing. The main attraction for me is always David Rolley, the droll and super-smart fund manager on the global fixed-income side of things, and someone who’s always good at making you look at the world in new and interesting ways.

This year’s lunch took place yesterday, and kicked off with Loomis vice chairman Dan Fuss coming up with a very interesting macroeconomic point. Right now, he said, about 56% of Americans over the age of 16 are gainfully employed. If that percentage were to rise to 64%, Fuss reckons, then the budget deficit disappears entirely. We’re not going to get there. But theoretically it’s possible, if the unemployment rate comes down and if people retire later, as is happening in Japan. And more generally it’s an important reminder that unemployment is a fiscal issue, and that anybody who wants to take the budget deficit seriously should put a lot of effort into increasing the number of Americans with jobs.

Rolley then gave a short talk about QE2 and its effects, which he reckons have been large and global. It’s “the most important single factor that explains why markets are where they are now”, he said. And it was always intended to move markets: the idea wasn’t to move long-term interest rates, said Rolley, but rather to create jobs by sending stocks up and the dollar down. That way companies can boost employment through trade revenues, rather than from money made by selling goods and services to overstretched US consumers.

The result, said Rolley, is that “inflation tolerance globally is being recalibrated”: the Fed has succeeded in giving markets a bit more of an inflation appetite than they’ve had in recent years.

That was the good news. As for the biggest risk to the system, Rolley said that a huge amount of the liquidity pumped into global assets by QE2 was finding its way, in one form or another, into leveraged bets that China will continue to grow at roughly a 9% pace. Which is a reasonable assumption — nearly all forecasters believe it, and Rolley’s no exception. But in the unlikely event that China doesn’t continue to grow that fast, there could be serious repercussions, with a flight out of risk assets and into safer areas like Treasury bonds and JGBs.

Right now almost no one is betting that long rates in the US and Japan are going to go down rather than up, and as a result there’s a technical bias for government bond markets to rally. At the same time, however, as Dan Fuss pointed out, long-term rates are going to revert to the mean sooner or later, which means a significant rise in yields which could happen quite suddenly and dramatically.

All of which is very good reason for individual investors to shy away from investing in the bond market directly, and instead pick a big and sophisticated bond fund. Managing risks in this market is really hard at the best of times, and pretty much impossible if you have less than a few billion dollars to play with.

And one last thought from Rolley, who said that he was wary of single-name credit default swaps because managing the counterparty risk was so onerous. If such swaps became centrally cleared, he said, he’d write a lot more of them. And what’s more, such a move would be good for the banks as well, since his counterparty exposure to them would fall significantly, freeing him up to buy things like Coco bonds from them. I doubt many banks in the CDS market would buy that argument, though.

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