The Fed's May meeting provided us all with a few answers but probably posed a few more questions of the US central bank than chairman Ben Bernanke was anticipating. Volatility on any measure shot up as Treasury yields backed up and investors sought to pare back risk in their portfolios. Leveraged exposure in higher risk markets such as high yield and emerging markets made those asset classes especially vulnerable. Emerging markets, both bond and equity, had long been beneficiaries of elevated demand as policy measures around the world encouraged greater risk-taking – any threat of a reversal of policy is likely to cause some reversal.
It is clear to us that the Fed has been a little shocked by the market volatility created by its tapering suggestion. On a number of occasions, Fed members including Bernanke have been using any opportunity to get the genie back into the bottle.
Bernanke himself has been increasingly explicit with his comments regarding tapering. As recently as 18 July this year, he said: "If we think that mortgage rate increases are threatening [the housing market’s] progress, then we would have to take additional action in the monetary sphere."
He is telling us that tapering and changes in policy are very data dependent. Good data and ongoing recovery means policy measures can be gradually reduced; bad data and they will not.
This all seems perfectly fair to us and is entirely logical – quantitative easing cannot stay in place for ever and improving economic prospects should be the environment in which the Fed can ease back on the gas.
It is worth highlighting that tapering of QE is not tightening, but loosening less, and this first step in changing policy is because the world – or the US at least – is getting better. Similarly, we are sure that if the US economy slows once more, the medicine will be administered again.
Where does that leave markets? The central banks' sponsored asset bubbles created over the past few years have generated some good returns for bondholders and shareholders alike, but now are suddenly worrying about what’s next.
Consensus views have quickly become that bonds are a bad place to be as yields have to rise. We feel sure they will do so over time, but are less sure they are going to in the near-term.
Inflation remains subdued; the global growth outlook is uncertain, especially in developing markets; and the on-going risks from the periphery still mean that "safe haven" assets like Bunds and gilts have a place for some investors.
On top of that, pension funds also in the UK and Europe have an ongoing structural demand for investment grade bonds – both sovereign and corporate.
As we have said before, even in the US where growth is more robust, policymakers will be keen to control yield levels to some degree given the negative impacts of a sharp rise on both the consumer and banking sectors.
The bond bubble may be nearing its end and will be slowly deflated, but it cannot be allowed to burst. Too many parties with too much to lose are exposed to longer-dated bonds so the path to higher yields will most likely be a longer one than the early summer volatility spike suggested.
A flexible approach to asset allocation and duration management is clearly needed but bond returns in the second half may still be a surprise to some, especially in credit.
Roger Webb has headed up the £117m SWIP Strategic Bond fund since its launch in June 2010.
Performance of fund vs sector since launch
Source: FE Analytics
The fund has returned 25.6 per cent over the period, marginally beating its IMA Sterling Strategic Bond sector average.
The fund requires a minimum investment of £1,000 and has ongoing charges of 1.38 per cent.