Traders switch to FX after central banks numb bond markets

Interventions made fixed income less attractive for short-term bets, analysts say

Foreign exchange is becoming the new playground for bond investors looking to profit from sharp moves in prices, after central banks’ aggressive response to Covid-19 robbed them of opportunities in fixed-income markets.

Government bond yields have sunk to record lows this year — reflecting rising prices — after central bankers moved swiftly in March to slash interest rates and launch bond-buying programmes to counter the economic effects of coronavirus. Investors now face not only the prospect of near-zero or negative returns from the safest debt, but also a collapse in volatility that has frustrated short-term bets.

But while bond markets are moving sideways, currency markets remain jumpy. Even after the most intense phase of the Covid-19 crisis, volatility is well above levels seen 12 months ago, based on broad measures of price moves such as the JPMorgan Global FX Volatility Index.

Sterling has been a prime example, losing 4 per cent of its value last week after Brexit fears came back to the fore. UK gilt yields, meanwhile, were largely stable.

“In this low-yield world, FX will become more important and bond managers will have to go into currencies more to generate returns,” said Jack McIntyre, a portfolio manager at the global fixed income fund of Brandywine Global, a Philadelphia-based asset manager.

Bond markets went into meltdown at the height of fears over the pandemic in March, as even the safest government debt succumbed to a sell-off. Central banks’ drastic actions restored order but also led investors to bet that policymakers would seek to control bond prices for years to come.

The ICE BofA Move index, which tracks the expected volatility of the US Treasury market, has hovered close to record lows since May, after rising to its highest level in more than a decade in March.

Since then, currencies have become the pressure valve for macroeconomic adjustments, investors say, as well as the main market for trading political events.

The dollar index has lost more than 6 per cent since the start of April, declining steadily as confidence returned to the global financial system and investors digested the impact of lower interest rates in the US as well as the hit to the economy from Covid-19. Over that time, the 10-year US Treasury yield has not strayed far from its current level of just under 0.7 per cent.

As a result, the so-called bond vigilantes — investors who would punish free-spending governments by betting against their debt — have turned their firepower on foreign-exchange markets instead.

Dickie Hodges, a bond fund manager at Nomura Asset Management, bet earlier in the summer that huge amounts of bond issuance by the US government, along with the Fed’s increasing tolerance for inflation, would lead to higher yields on US Treasuries.

But as it became clear that the Fed’s heavy bond purchases would keep a lid on yields, he switched strategy, instead using currency options to position for a weaker dollar.

FX is much more volatile than bonds, therefore there are more opportunitiesRussell Silberston, investment strategist at Ninety One

“Rates markets can’t really go anywhere at the moment because then governments wouldn’t be able to fund themselves, and the Fed and other central banks won’t let that happen,” Mr Hodges said. “That’s pushing people down other avenues including FX.”

Some investors also worry that government debt no longer serves its traditional purpose in a long-term investment portfolio as a counterweight to riskier assets, tending to rise when stocks fall and vice versa.

“Bonds are still safe-haven assets but the problem is that you can’t balance equity losses with bond gains any more because of the very low yields,” said Kaspar Hense, an investment-grade bond fund manager at BlueBay Asset Management.

Russell Silberston, investment strategist at Ninety One, said the asset manager was increasingly using bets on a higher Japanese yen or Swiss franc — currencies that typically rise in times of market stress — as an alternative hedge for its exposure to stocks. “FX is much more volatile than bonds, therefore there are more opportunities,” he added.

While central bankers have put a cap on volatility in fixed income, Paul Robson, a currency strategist at NatWest Markets in London, said they would “struggle to do the same in currencies”, partly due to the political sensitivity: the US keeps a watchlist of countries it deems “currency manipulators”.

Traders are bracing for a stormy end to 2020. Options markets are pricing in big swings in exchange rates around the time of the US presidential election in November, and as the Brexit transition nears its end.

Exposure to currency swings is not always going to be welcome in portfolios designed to be low risk, said Brandywine’s Mr McIntyre.

“If a fixed income manager loses money on currencies, the dissatisfaction tends to be much bigger than the reward for making a profit,” he said. “Nobody loves volatility, but if you are looking for currencies as a source of return, you will have to tolerate it.”