The market’s reaction to the US Federal Reserve’s meeting in September is likely to be “brutal”, according to City Financial head of multi-asset Mark Harris, who warns that the recent falls in the bond market are only a warning shot of a much bigger correction likely to occur later in the year. 
Following a surprisingly strong year in 2014 when bond yields moved down against expectations, yields on sovereign debt in the likes of Germany, US, UK and Japan have risen substantially over recent months despite ultra-low interest rates, weaker than forecasted growth and quantitative easing from the ECB and the Bank of Japan.
The initial price falls in April and early May caused many to question whether it was the end of a multi-decade rally in the asset class while others feel investors have overreacted and therefore the higher yields on offer present a buying opportunity – especially given the macroeconomic headwinds facing investors.
However Harris, who heads up the group’s fund of funds range, sits between the two camps.
The manager expects a decent period from bonds over the coming months as the market becomes concerned about weak US GDP figures but then severe volatility in September as growth bounces back and the US Federal Reserve is forced to push up interest rates.
“Here is the puzzle. Why, in an environment where the data has been fairly weak and rate expectations in the US have been pushed further out, have bond yields been going up? It doesn't make any sense,” Harris (pictured) said.
“Is this a correction or a change in trend? That's the big question for everyone. We are still working it through but I suspect, at this stage, it is more of a correction than a complete trend change. However, we think it is extremely difficult to make money from bond markets at the moment but it is easy to lose money and lose it very quickly.”
He added: “It is a very challenging environment that will trick a lot of people. If that is a warning shot of what we believe could occur later in the year, it is going to be fairly brutal because liquidity just dried up.”
According to FE Analytics, developed market government bond indices delivered double-digit returns last year following concerns about equity market valuations, geo-political tensions, falling inflation expectations and also because they were largely under owned by investors after a difficult 2013.
Performance of indices in 2014
Source: FE Analytics
However, despite flat and falling inflation levels, large-scale stimulus programmes in the eurozone and Japan and weak first-quarter GDP data in the US, bond yields have surged.
FE data shows the BofA ML Euro Government Bond Index is down 7.67 per cent since the start of the year while the Barclays Sterling Gilts Index and Barclays Global Treasury Index have both lost more than 5 per cent since early February.
Performance of indices in 2015
Source: FE Analytics
It means that 10-year German bunds now yield 0.6 per cent (having been less than 0.2 per cent just a month ago), 10-year treasuries yield 2.2 per cent and 10-year gilts yield 1.95 per cent.
Harris says the major reason for this fall was the lack of underlying liquidity.
“Banks are under more regulatory pressure, their balance sheets can't take more inventory, there aren't as many participants now, people tend to sway into one-way positioning and want to get out, and there is no-one to be on the other side of it,” he said.
The manager admits that he was caught out by the strength of the bond rally last year, but says 2015 has largely played out as he expected as he thought volatility was “going to rise and it was going to rise substantially”.
“What we said was bonds have had a fantastic year and that everyone had gone into the crowded positioning of being long again,” he said.
“Why is bond volatility going to go up? Firstly, growth expectations are too high initially so they will ratchet down and that will bring down interest rate expectations – but then we think there will be quite a strong rebound in growth and that will push rate expectations back up.”
“Why? That is because there are a lot of crowded positions in markets because these are markets that are very difficult to interpret and it’s not a normal cycle.”
“Investors get very crowded and then get whipsawed because the data sends them the other way – that's when you get these huge movements and this year the recent move in German bund yields was greater than anything we have seen in the last 20 years.”
Harris, who has comfortably outperformed his peers since he launched City Financial’s fund of funds range in January 2013, accepts there are a number of factors which could challenge his prediction, though.
Performance of manager versus peer group composite since Jan 2013
Source: FE Analytics
The main caveat, according to the manager, is the trajectory of US growth over coming few months. US GDP grew at a sluggish annual pace of 0.2 per cent in Q1 (down from an annualised 2.2 per cent in Q4 2014) and many expects think it will remain lacklustre or even contract in the second quarter.
However, he thinks this uncertainty is all part of the “whipsawing” trend which will catch out investors over the coming months.
“The danger of me forecasting certain things is that you have a very wide range of possible outcomes right now. Some people could point to the US and say it is almost in recession; others are saying there is a lot of pent-up demand and it’s going to come through and growth in the second and third quarter is going to be very strong, which will put up interest rates,” he said.
“I would say growth will bounce, it won't be as strong as the more bullish commentators are saying, but that will provoke a response from the Fed and that will mean they push rates up in September.”
There are a number of other industry experts who think the recent bond market rout is a warning shot of more severe events to come.
One of whom is notable market bear Bruce Stout, manager of the ever-popular Murray International Trust, who says the recent correction is “unequivocal evidence of structural distortions to consumption, wage distribution, savings and the credit cycle” within the developed world thanks to policies from central banks.
“The reluctance of bond and equity markets to adequately price for credit risk and inflate valuations irrespective of prevailing sovereign or corporate fundamentals uncomfortably stretches the boundaries for savers and investors alike,” Stout (pictured) said.
“Against this backdrop the strategy remains cautious, disciplined, valuation orientated and focused on capital preservation.”
Harris also says that the equity market will be unlikely to ignore bond market volatility later in the year.
“I don't want to be too negative. I think that equities will be on a generally upward path into that August/September period, but I think you might find another disruption that is even greater than the one we have just witnessed around that Fed meeting,” he said.
There have been a number of occasions in the past when central bank policies have caused both equities and bonds to fall together, such as during in May/June 2013 when Ben Bernanke warned the market he would taper quantitative easing and in 1994 when the Fed unexpectedly raised interest rates.
Performance of indices in 1994
Source: FE Analytics
However, the manager is constructive on equities overall and in an article later this week he highlights the areas investors should now be focusing on.
Harris, who previously ran multi-asset portfolios at New Star and Henderson, currently heads up five funds of funds in the Investment Association universe such as the five crown-rated City Financial Multi Asset Balanced fund – which he had previously managed prior to joining his new firm.
It has been a top decile performer in the IA Mixed Investment 20%-60% Shares sector over three years with returns of 40.53 per cent and currently only holds 28 per cent in fixed interest – with this limited to more esoteric areas of the bond market such as the VPC Specialty Lending fund.