"Lest investors are tempted to get too exuberant about the latest run of economic data prints, central bankers were out in force to remind markets that downside risks still exist: Bernanke "...need continued monetary policy accommodation to boost demand..." and King "...examine the case for QE every month...". This bout of verbal easing is actually rather good for fixed income markets. It serves to remind investors that the world remains a dangerous place and reinforces the fact that one of our key enemies, interest rates, are set to remain low for a long time.
"The more difficult question then, is what sort of fixed income? Government yields, close to generational lows, still look unattractive and we expect Treasury yields to bubble higher over the next few months as the Eurozone risk premium is unwound and as the market adjusts to the reality of better economic data prints. The attractiveness of spread sectors was starkly illustrated this week by the Russia deal and a book over US$25bn scrabbling for US$7bn of bonds. Emerging market debt continues to be one of our top picks as do other spread sectors such as high yield, where both fundamentals and valuations look good.
What, then, can go wrong?
"Perversely, with a lot of the systemic risks contained (at least in the short run) the real risk is probably that the incipient recovery forces risk free yields meaningfully higher, an act in itself that raises the cost of capital to a punitive level and chokes off the recovery. Recent central banker jawboning suggests that they are alert to this and will lean against this risk. Portfolios, with healthy allocations to spread sectors are well positioned as we move to navigate the next quarter."
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