‘Who on Earth Bought This?’ Franklin Debt Chief Warns of Danger
(Bloomberg) -- As Wall Street trumpets this relentless era of ultra-cheap money, contrarian Sonal Desai has a warning for her peers plunging into long-dated debt like no tomorrow.
“Markets are over-estimating the Fed’s ability to anchor long-end rates -- they’re also over-estimating the Fed’s fear about the underlying real economy,” said the chief of Franklin Templeton Investments’ $150 billion fixed-income unit.
She reckons one more interest-rate hike is in the cards in 2019, shrugging off market projections that growth and inflation are slowing. The firm’s debt titan sees 10-year U.S. Treasury yields climbing to 3 percent or more this year, even as traders tank up on dovish monetary bets.
“I know that puts me beyond being in a minority, it puts me way out there, off the reservation so to speak,” she said in an interview in London. While many strategists and money managers sound cautious on interest-rate risks after the rally in recent months, yields tell another story. “If it’s a consensus view that people don’t like duration, my question is, who on Earth bought this stuff?”
The fear of stoking asset bubbles should weigh on monetary policy makers, Desai warns. It’s an eye-catching worldview for a benchmark-orientated manager who lacks the full flexibility to snub the herd. From her perch in San Mateo, California, she’s acutely exposed to all manner of interest-rate risks across her portfolios from Treasuries to credit, emerging markets and loans.
But “way out there” is a comfortable place for the investor.
Before taking over the fixed-income portfolio at the end of last year, she helped manage the Templeton Global Bond with Michael Hasenstab, a famous contrarian in the world of debt investing. Together, they staked billions shorting duration in a wager longer-dated yields will break out from their post-crisis slumber.
Several funds in the broad fixed-income unit are running duration lower than the benchmark, while the Franklin Strategic Income has a duration of about 3.5 years, some two years shorter than the index.
“Right now, I think markets are wrong in assuming the next rate move from the Fed would be a cut,” Desai said.
She cites the favorite recipe of die-hard bond bears: Sustained price growth and a relatively tight labor market -- ingredients that have hitherto largely failed to serve up a sustained sell-off over the years.
On paper, this call gets some support right now from U.S. unemployment close to 50-year lows, Friday’s report showing first-quarter U.S. growth at 3.2 percent, and record stock prices. While Fed funds futures show traders wagering the central bank’s benchmark will fall this year, Goldman Sachs Group Inc. said last week it reckons the next move is likely to be a hike, potentially in the final quarter of 2020.
Dan Ivascyn at Pacific Investment Management Co., for one, is playing defense.
“Rates are at risk of a second-half pullback,” the chief investment officer said in an internal video broadcast published last week. “We could see an uptick in growth, even an uptick in inflationary pressure, and that would lead to likely higher rates.”
Federal Reserve officials conclude a meeting on Wednesday amid expectations they will keep rates on hold.
Whether it’s the Fed’s fear of entrenched disinflation as growth cools, a bet that long-term neutral rates are aggressively low, or ceaseless fixed-income demand to hedge stocks, investors are taking big duration bets as inflows boom.
The term premium, or the compensation investors demand for holding longer-maturity U.S. debt over short-term obligations, remains close to record lows.
Still, Desai’s caution is warranted by the theory. A half-percentage point jump in yields would spur more than a $1.5 trillion loss to the value of global high-grade bonds, according to one measure of interest-rate sensitivity.
The risk is that investors are scooping up bonds safe in the knowledge the U.S. central bank is at their beck and call, just as opaque markets like private debt boom, Desai warns.
“It’s a moral-hazard play largely -- the notion that the Fed is always going to come and bail us out,” she said. “The pivot in the first quarter was essentially the Fed choosing to exchange volatility today for what actually is an unknown quantity of volatility in the future.’’
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