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STATE OF AFFAIRS
I explain the title in the conclusion of this letter. But first, global bond markets are in a state of anxiety. Selectors of bond funds get nervous as year-to-date (YtD) performances sink deeper into negative territory. Bond fund managers are put to the test. Alongside dealing with decision-making under rising bond volatility conditions, they are required to balance short-term protective portfolio accents without losing their eye, and faith, on the longer-term potential that is on the rise. The impact of the reflationary promise, expecting high nominal GDP growth over 2021 and beyond, has firmly steepened the US yield curve. Reflation success connects directly to a process of higher inflation expectations. However, the yield curve steepening has not been a worry for equity markets, as the bulk of the move is linked to improving growth prospects. The US FED has assured market participants that policy rates will remain anchored for at least another couple of years. Moreover, with central bank asset purchases well in place, the probabilities of a taper tantrum in bond markets, like events from 2013, are modest. However, un-anchoring of forward guidance and/or QE intensity might lead to a higher term premium.
Thus far, yield curve steepening has been limited to reflation expectations. These translated best not only in broad dollar government bond markets in general (Australia, New Zealand, Canada), but also in the US Treasury market in particular, as measured through the rising market-based inflation expectations. US 10-year inflation expectations or break-even rates rose as high as 2.25% only to drop almost 10bp over the past week to close at 2.16%. Effectively, the rise of break-even rates since April 2020 was propelled by lower real rates and a measured lift in nominal rates. Last week, this dynamic changed. The market sold-off more in real rates than was the case in nominal rates. Bond markets have reached the point where they assess that the combined impact of monetary and fiscal policy initiatives might lift potential growth rates over the next three to five years. Fair enough. Last week, we flagged that under such a short-term reflationary scenario, the US 10-year note could move towards the 1.45% area. Including a lift in economic growth rates and an extra dose of term premium, our base case scenario still calls for 1.60% on 10-year US rates by the end of 2021. How come?/span>
The risk scenario is built around a scenario where the US FED hesitates in their resolve to express enforced forward guidance in policy rates or QE support. Indeed, it is as if the genie is out of the bottle, as market parlour around QE tapering over 2022 next to an initial H2 2023 lift in US policy rates gains traction. What are the odds? What are the odds that the US FED crumbles under market pressure, as we go through a higher inflation episode from April through June? What are the odds that the FED makes a policy error, as they face higher growth and inflation over their typical projection horizon? The market is really testing the FED’s adherence to their new Flexible Average Inflation Targeting rules. A policy error might cause a further steepening of the yield curve, as bond investors will require more term premium protection. Monetary policy connects directly to the development and extent of negative or positive term premium. The combination of reflationary momentum (supporting inflation expectations and real growth) with un-anchoring of monetary policy (pushing term premium higher) has the potential to catapult 10-year US rates over 2.00%. Markets tend to attach probabilities to base-case and risk-case scenarios. If, for arguments sake, we attach 75% to ‘reflation’ only impact with a 25% probability to increasing term premium and higher potential growth, we still arrive at result of about 1.60% in US 10-year rates (i.e. 75% x 1.45% + 25% x 2.00% = 1.5875%). In the forward-rates space, we are starting to price both base-case and risk-case scenarios: 5 year US Treasury rates 5 years forward closed at 2.15%. Such a level takes us back to the end of 2019. Back then, we had a fairly flat US yield curve with 5 year US rates around 1.70%, 10-year at 1.85% and 30-year rates at 2.25%. 30-year rates have nearly closed that gap, printing at 2.14% Friday.
Returning to the anxiety theme we touched upon in the first paragraph, when we look at the damage inflicted since the start of the year, we are confronted with a -2.25% for European Government Bonds (EGBs) versus a -0.71% for European Investment Grade (IG) credit. Remember that European corporate bonds returned just above half the figure (+2.73%) that EGBs (+5.25%) posted over 2020. The IG resilience comes from a notable shorter average duration next to the unrelenting ECB corporate bond purchase program. European High Yield (HY) takes first place with a distance as the only main bond sector in positive territory at +1.19%. Turning our attention towards global bond indices we find little comfort with the JP Morgan Global Government Bond (GBI) index at -1.72%. The JP Morgan GBI-Emerging Market Global Diversified index went from +0.50% towards -0.92% over the past week. Let’s face reality…we can expect that 2021 will be a challenging year for bond investors.
On the positive side we observe that balanced portfolios, from defensive to dynamic, are handsomely in positive territory. As long as the reflation narrative prevails, equity markets might expose high resilience to rising rates. Higher potential growth rates connect directly through higher real rates. If however, US 10-year real (and nominal rates) would spike another 60bp to 75bp from the -0.81% (or 1.34%) close, on the back of fear for an early lift in monetary policy tightening (QE taper or policy rates), equity markets might panic. But again, that would be good news for fixed income investors, as that would represent a ‘Buy on the dip’ opportunity in bond markets. I never fully understood that investors use this ‘buy-on-the-dip’ heuristic for equity markets, whereas it works always in bond markets… Though I admit, bond markets require patience. A virtue that often gets lost these days.
Even with Presidents’ day shortening the week, the US Treasury market sell-off was quite aggressive. Even if 2-year Treasury rates were as good as unchanged, it is worth mentioning that they dropped from 0.111% to 0.108%. A small decimal difference, but an important one, as the Treasury General Account (TGA) at the FED starts to get depleted. This will inject about USD 1 trillion over the next 6 months and anchor short-term rates at worst, or drive them lower at best! On the long end of the yield curve it was less fun, as 10-year rates spiked 13bp towards 1.34%, versus a similar 12bp rise on the 30-year point closing at 2.135%. As mentioned, US TIPS investors went through a devastating week as 10-year real rates got caught in a reverse tailspin and thrown back by 20bp from -1.01%, finishing at -0.81%. 30-year real rates were not spared, as they spiked from -0.17% to close at 0.00%! 30-year real and nominal rates are both back in positive territory.
The correlation between US rate markets and core European rate markets reached almost 1. 10-year German bund rates added 12bp, closing at -0.31%. Over the month of February this all-important benchmark rate breached through -0.50% and pushed towards the often mentioned lower bound of the -0.30-0.50% range that was in place over most of 2020. Bond investors across Europe study the reflationary vaccine that the ECB and the European Commission delivers. We suspect that several booster doses will be required in order to lift 10-year bunds towards 0.00%. But then again, markets might price such event early… Global bond markets have been shaken and are fully awake. The return of bond vigilantes might be around the corner. Time will tell.
We have to go back to the first half of May 2020 to find a -40bp weekly performance figure for quality European corporate bonds. IG credit was trying to defend its resilient character. It succeeded against the -1.07% retreat in EGBs, but still leaves a sour taste. As European IG is a rather modest duration asset, it will become harder to recover into positive territory the longer a ‘higher rates momentum’ dictates the order of the day. We will need to pierce through historical low spread levels in order to gain excess return versus government bonds. European HY was able to eke out a positive result, adding 8bp for a +1.19% over 2021. As stated above, the reflation narrative is supportive for risk assets.
The emerging markets (EM) rally took a breather, as rising core rates weighed on risk appetite. The JPM GBI-EM index for local currency debt lost -1.46% during the week (-0.98% in EUR terms). The yield of the GBI-EM rose 17bp to 4.46%. The impact from rising local rates came in at -0.82%, whilst the EMFX retreat was negative in USD (-0.65%) and EUR (-0.12%). Despite spreads to US Treasuries increasing by 4bp only, the JPM EMBIG lost -1.08% due to adverse US duration effects. We repeat our view that, contrary to 2020, duration gains might be more limited for the EMD investor, while EMFX should bring positive performance to the local currency asset class, due to its positive beta to the global growth recovery.
Geopolitical noise increased slightly on the back of a press article, relating that Chinese officials were exploring ways to curb supplies of rare-earth minerals that are critical to the US defence industry. It becomes clear that China policy staffers within the Joe Biden administration are known for their hawkish stance towards Beijing. Tensions between the two superpowers is unlikely not abate.
After Mexico last week, Indonesia’s central bank reduced its repo rate by 25bp and revised its growth expectations downward amid resurgence of Covid-19 outbreaks. The move came on the back of the good performance of the Indonesian Rupiah and soft, below target, inflation readings. Meanwhile, the Philippines is seeing an inflation surge above target due to a spike in pork prices. This will constrain policymakers in their accommodative stance and could make the country the first in the region to hike rates.
In December 2020, the Uruguayan Congress passed the 2020-2024 budget law in order to stabilise the debt burden and foster sustainable finances over the medium term. Notwithstanding a 5.8% contraction of the economy last year, all criteria were met, resulting in a gross central government debt at 61.5% of GDP. This reaffirms the safe-haven status of Uruguay in the Latam region. The 2021 financing program looks to develop the fixed rate global UYU curve.
The dynamic triangle is a straightforward representation that intuitively explains the impact of unstable changes in term premium, real rates and inflation expectations. Each angle has a direct influence on the direction of real and/or nominal rates. Currently, the sharpest angle relays to increasing inflation expectations as a result of reflation policies. The US saw the most aggressive expansion of inflation expectations. Europe lags a lot and inflation expectations plateau given lack of credible fiscal policy. The second angle of the triangle relates to the level of real rates, as influenced by movements in potential economic growth rates. Did we witness a reversal in real rates over the past week? The third, and currently softest angle, represents term premium. Term premium typically increases, as market participants prepare for the advent of a hawkish monetary policy. It remains a difficult task to measure the dynamics that occur across these three vectors in real-time. The triangle notion gives you a simple guide to assess the intensity of each vector.
Experience goes some distance in the comprehension of this dynamic triangle. We are not in a 1994, nor 2013 style correction in rate markets. Those were clearly driven by monetary policy surprises and aggressive spikes in term premium. The current episode is complicated. Yes, we already have seen US inflation expectations rise above target. We might have added some higher potential growth through higher real rates over the past week. We have not added a lot of term premium. I reckon that central banks want this angle to remain at bay. QE is the vaccine that enables just that. To end on a positive note, whereas 1994 and 2013 where dismal years, 1995 and 2014 vindicated bond markets with a stellar performance.