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STATE OF AFFAIRS
In order the give a proper answer to the question in the title, we need to define a bond bear market. And here we immediately are confronted with the lack of any standard, generally accepted definition. In equity markets, a bear market becomes newspaper headline stuff the moment a correction moves across the 20% threshold. In bond markets some commentators call for a bond bear the moment long term bonds with maturities above 20 years fall by more than 10% and intermediate bonds with maturities between 5 and 10 years fall by 5%. Long-term US Treasury bonds fit the bill. Over Q1 2021, expressed in USD, the long end of the market dropped by 14.13%. However, the intermediate part for US Treasuries adjusted by 3.15%, whereas intermediate corporates fell 4.23%. In Europe, we observe a similar picture for core 30-year EMU government bonds like Germany and France that retreated around 11%. However, 30-year Italian BTP’s fell back a mere 4.5%. So, for investors that were ‘only’ exposed to long-maturity nominal US or core European government bonds, we can say that we entered a bear market. Intermediate solutions, which constitute the bulk of bond portfolios, are not in bear territory. Anno 2021, we are going through a bear-steepener sell-off in rates. These are the most dangerous, as well as the most difficult ones to overcome. Dangerous in the sense that investors easily lose their nerve and start mixing up return profiles across bond sectors. Some bond sectors can hold their value better or even thrive when other sectors fall victim to bear conditions. Difficult in the sense that an aggressive sell-off in long term bonds (30-year bonds for instance) cause short-term pain. However, the moment rates consolidate, and momentum turns positive again (rates go down), these sections of the bond market can properly boost returns. The adagio that we are all aware of in equity markets (i.e. that one cannot miss the early equity recovery episodes in order to generate decent long-term results) is also present at the long end of yield curves.
Let’s dig a bit deeper into the bear market analogy and look at broad, aggregate indices. We compare the Bloomberg Barclays US Aggregate Total Return index with the Bloomberg Barclays Euro Aggregate Total Return index. The US Aggregate index has a market value of about USD 25 trillion whereas the Euro Aggregate index represents EUR 13.2 trillion of government, government-like, agency and investment grade (IG) corporate debt instruments. Over Q1 2021, the US Aggregate declined by 3.37% in USD terms, the Euro Aggregate lost 1.9%. Interestingly, one must go back to Q3 1981 in order to find a higher negative quarterly return. Q3 1981 posted a -4.07% result. The US Aggregate index that was launched in 1976, saw its worst quarters over Q1 and Q3 1980, posting returns of -8.71% and -6.56% respectively. Back then, the US 30-year long bond saw a maximum drawdown of almost 21%. The maximum adjustment for 5-year Treasuries reached almost 9%. The 1969-1970 bear market was similar in intensity for long maturity bonds, but less so for intermediate bonds. Anyway, US bond investors had to look back 40 years for such a bad quarter! One can state that the bond bear in the US is awake and well. The Euro Aggregate declined by 1.90% over Q1 2021. Since its launch back in 1998, this broad index has posted 5 quarters with a negative return of more than 2%. The one we remember best was Q2 2015: the infamous Bund VaR shock, when 10-year German rates went from close to 0.00% mid-April 2015 towards 1.00% by mid-June. Over Q2 2015, the Euro Aggregate index fell 4.35%. Today the US Aggregate has a yield of 1.56%, whereas the Euro Aggregate has a yield of 0.04% for duration profiles of 7.7 years and 6.5 years respectively. All-in-all, the damage has been limited so far. The moment investors complement core bond exposures with inflation-linked bonds, pure IG or high yield (HY) solutions and Emerging Market (EM) government exposure, the results brighten up even more. So, history has proven that nominal drawdowns are temporary. Over time, nominal return setbacks in bonds will disappear. However, the biggest enemy is the loss of purchasing power over the long-term due to inflation.
Taking long-term inflation-adjusted or real US government returns on 5-year bonds and 30-year bonds, the picture is somewhat sobering. Between early 1940’s and 1981, US 5-year bonds were down 40% in real terms. Long-term 30-year US Treasuries lost 60% of their value after inflation over a 40-year period. In the early 1940s, the US FED entered into a regime of yield curve control, capping 10-year to 30-year US rates at 2.5%. That was abandoned by 1951. The first true bear US bear market was encountered by 1969-1970. Long bond rates peaked just above 15% in 1981. The astonishing loss of value was a result of an average US CPI of 4.8% over that 40-year era. Currently US CPI YoY sits at 1.7%. We can expect that over Q2 we will see high volatility in readings that can range between 2.5% to 3.50%. Over H2 2021 US CPI should return towards 2.00-2.50%. That is consensus. But what is striking is that 4.8% is not that far from 2.00% to 3.00%, on average. Bond investors need to remain extremely vigilant over the next 2 to 3 years. Clearly the fiscal-monetary entente has kicked off a new market regime. Back in the days, between 1941 and 1951, the FED simply capped rates, even under conditions that saw very high inflation after 1945. Today, the FED has launched Average Inflation Targeting. An experiment that has not been tested. The 5Y5Y forwards in US Treasuries moved above 2.5%. This is an attractive investment level, if the FED can honour their 2% inflation objective. It becomes a completely different ballgame if the anchor comes loose, and average inflation rise to 3%. Let’s not go into a scenario of 4%…levered financial markets would enter a historically-unseen bear market across asset classes.
US Treasury rates are consolidating. Over the past two weeks, 10-year Treasury rates were pulled towards 1.65%, closing at 1.66% last Friday. We noticed high interest in the 30-year part of the curve. The 10 to 30-year rate differential dropped 3bp to finish at 67bp. US inflation expectations dropped over the Easter break, as the FED announced more intervention in nominal Treasuries up to 20-years without mentioning intent on the part of US TIPS. Their control over real rates, through US TIPS QE, might start to influence market functioning. With 22% of all outstanding US TIPS on the balance of the FED, one can state that the FED is in control of the market-based inflation expectations…
European Government Bonds (EGB’s) retreated a hefty 45bp in performance over the past week. Since the start of Q2, they have been down 0.62%. The JP Morgan EMU government index slips towards -2.63% year to date. Anxiety is on the rise. Especially because periphery 10-year rates underperformed vis-à-vis the German reference rate. With 10-year bunds finding a new anchor around -0.30%, one observes nervousness across Italian, Spanish and Portuguese bond holders. The 10-year BUND-BTP spreads flipped back above 1% towards 102bp. But also, Spain and Portugal added between 4bp to 5bp spread compared to Germany in the 10-year sector. Even the 30-year sector, with yields around 1.30% compared to 0.24% for Germany, could not resist and hold onto end of Q1 spread levels. The ECB is losing more credibility with every ECB meeting and press conference that passes. They stated that Q2 would see a ramp-up in PEPP purchases. The results are not there…
European IG and HY corporate bonds both booked about 20bp in the weekly performance tables. Year-to-date, investment grade credit sits at -0.69%. The sector held firm last week, posting +0.01% against rising rates. The European high yield sector put in an astonishing +0.60% since Q2 started. Year-to-date, the high yield index pockets a decent +1.79%. The growth recovery is supporting or lifting IG and HY sectors in the EU. In the US, because of higher IG corporate duration, the sector faces stiffer influence from rising rates. In US HY, spreads to government bonds remain on a tightening path. On a spread basis, the US passed their EU counterparts. The number of distressed bonds touches new lows. No one will be left behind apparently.
The EMs started the new quarter on a solid footing. The yield of the emerging markets local currency index (GBI-EM) lost around 10bp and the Emerging Market Currency Index gained 0.3%. Currency volatility showed a mild drop from 11.00 to 10.50. Peruvian Sol (+3.05% in EUR terms) , Brazilian Real (+1.30%) and Polish Zloty (+1.05%) gained most. India Rupee (-3.60% in EUR terms), Russian Ruble (-1.90%) and Thai Baht (-1.60%) posted the most negative returns.
Peru will hold Presidential and Congressional elections this weekend. There is very little certainty on who will make it to the second round. Last week, several polls were published that showed some consolidation of support around centrist presidential candidates. Most polls have Yonhy Lescano in the lead, followed by Keiko Fujimori or Hernando de Soto. More importantly, Verónika Mendoza, the most left-leaning candidate, failed to gain ground in these surveys. Markets have reacted with relief to these new polls on the general view that the most moderate candidates have advanced. The USDPEN rate, which traded at an all-time high on Thursday, April 1, has strengthened from 3.77 to 3.59. At the same time, the yield on the 10-year bond fell from 5.00% to around 4.50%.
The National Executive Committee of the ANC in South-Africa last week, endorsed its resolution that members charged with corruption or other serious offences should be forced to step aside from their positions in the party and state. All implicated officials, including Secretary General Ace Magashule, have until the end of April to voluntary step aside. Failure to do so will lead to suspension. The resolution strengthens President Ramaphosa’s position, increasing the odds for re-election next year and signals a clear shift towards internal accountability. The yield on the 30-year bond fell from 11.35% to 10.95%.
The Reserve Bank of India kept rates unchanged, but revised inflation forecasts slightly upwards from 5.00 to 5.20% for the second quarter. As of April 15th, the Central Bank will start buying up to INR 1 trillion (~USD 14 billion) government bonds. The RBI has been purchasing government bonds in the secondary market in the past, but committing to an amount, or more formal QE, was rather surprising. The Rupee reacted negatively. Indeed, expanding the monetary base and compressing real rates is not completely without risk going forward even with inflation within the 2%-6% target range.
So, Brazil’s Paulo Guedes sees USDBRL at 4.50? Brazil consumer prices for March printed at 6.10% year-on-year, above the upper limit of the Central Bank’s target range. With the policy (Selic) rate at 2.75%, the real rate is again the most negative of all emerging economies (-3.35%). First thing to do, in order to stabilise the currency, is to bring the real policy rate into positive territory. Last month’s pre-emptive 75bp hike, was not that pre-emptive after all. More, much more to come!
The use of “bond bear market” language should be treated with care. Actual bond bear markets unfold on the back of an un-anchoring of inflation. With US inflation expectations anchored around 2.00%, today’s US government bond markets offer value. Quality US corporate bonds offer deep value.
Aggregate bond indices have been coping well for the moment. Their fate is captured by the credibility of central banks to honour their inflation objectives. Over the past 10 years, they consistently undershot their inflation objective. The growing narrative that governments can use fiscal deficit spending without restraint is OK until it is NOT OK. Inflation will be the arbiter.
The bond markets are requesting higher inflation risk premiums. US markets have started to price this scenario more clearly than what we observe in European, Japanese and other OECD markets (Australia, Canada…).