Alan Howard, founder of the London-headquartered $40 billion hedge fund firm Brevan Howard Asset Management, is upbeat about the prospects for making money in the global bond markets in 2014.
“We are looking forward to an opportunity-rich year for rates trading in 2014,” writes Howard in his year-end letter to investors.
Howard, who is based in Geneva, also thinks Japan is still a great place to make money this year, telling clients that “Japanese authorities remain determined to reflate the Japanese economy.”
His investors are certainly hoping Howard will fare better this year. In the letter, Howard concedes to clients that his Brevan Howard Master Fund’s 2.59 percent return in 2013 was “disappointing,” especially given the strong gains it made in the first four months of the year, when the fund was up more than 7 percent.
“Unusually for the fund, interest rate trading was the main detractor, while trading in equity markets and foreign exchange provided positive returns,” Howard states in the letter. Howard had predicted in January 2013 that it would be a good year for macro managers. Instead, macro and other short-term trading strategies suffered one of their worst years in recent memory.
He elaborates that in 2013, performance was predominantly driven by three major themes. First, he was long the so-called Japan trade, which entailed being long Japanese equity indexes and short the yen. The second theme played off the U.S., going long the U.S. dollar versus a basket of other currencies. The third major play was aggressively going long European interest rates based on the belief that Europe’s ongoing disinflationary pressures would force the European Central Bank to cut rates.
Howard points out that these themes played out well during the first few months of the year, when Japanese equities rallied sharply and the yen sold off, while the U.S. dollar appreciated against its trade-weighted basket. However, he concedes that the European interest rate position was shakier, as short term rates surged in January before dropping through early May.
“During the latter part of May, however, a combination of stronger than expected U.S. April employment data and [U.S. Federal Reserve] Chairman Bernanke’s talk about the possibility that the Fed may taper asset purchases triggered substantial turmoil in financial markets that lasted several months,” Howard explains. “Trends reversed violently as market participants cut risk across multiple asset classes, and the fund gave back a significant portion of its gains during the period from late May to the end of October.”
Over the entire year, the Master Fund made money on the Japan trade and the long U.S. dollar trade. It also made small gains in credit in 2013, mainly from trading U.S. asset-backed securities.
Looking ahead through 2014, Howard is confident there is still plenty of money to be made in the Japan trade.
“Japanese authorities remain determined to reflate the Japanese economy and, even if they eventually fail, will take extraordinary steps in an attempt to achieve this goal,” he explains. “What is possibly different this time is that Prime Minister [Shinzo] Abe has a clear mandate to pursue his policies.”
Howard also notes that Bank of Japan governor Haruhiko Kuroda has “accepted the Fed’s strategy of influencing real economy outcomes.” So he highly doubts the BOJ and Japanese policymakers will change their current policies.
Howard says further policy actions may cause significant moves in Japanese equity indexes, the yen and — perhaps further down the road — Japanese government bonds. He also tells clients that the long European rates trade also seems to offer potential.
“The ECB was under little pressure to take action in 2013 because of a gradual improvement in Eurozone economic sentiment and data,” Howard explains in the report. Part of this improvement stemmed from a reduction of fiscal drag for most European governments, he adds, as euro zone governments shifted from further pursuing their austerity plans to dealing with their budget deficits. “However, as the fundamental fiscal imbalances have not yet been resolved, it is likely that the fiscal stance will become more restrictive in 2014, which may lead prospects for growth to deteriorate in the latter part of the year,” Howard states. He figures that if the disinflationary pressures in Europe persist, the ECB will need to take more aggressive monetary action.
Meanwhile, Howard says that as the Fed continues to scale back its huge asset purchase program, he is looking for greater opportunities to trade both U.S. rates and the U.S. dollar.
“The one-way bet on Fed accommodation since 2008 has made trading the U.S. dollar and U.S. rates a frustrating exercise for the last several years,” Howard states. “Fed policy is no longer a one-way bet, and the fact that the interest rate curve is as steep as it has been for decades demonstrates the broad range of expectations about future policy.”
Howard sees a material expansion in volatility in both the dollar and rates, which will provide opportunities to take advantage of “significant two-way moves” in prices, the shape of the yield curve and option volatility.
Hence, his assertion that he is looking forward to “an opportunity-rich year for rates trading in 2014.”
