Between a rock and a hard place

By Peter De Coensel,
CIO Fixed Income at DPAM



    • The phrase “Between a rock and a hard place” means that, when in difficulty, one is faced with a choice between two equally unwelcome options. The phrase applies to both the bond investor community as well as (to a certain extent) to policy makers. We will tackle both viewpoints.

    • With the pandemic as a global catalyst, fiscal and monetary policy makers started working on a new collaborative model geared towards soothing the social and economic impact.

    • In the US, fiscal policy has taken a firm lead. The US FED is preaching a steady policy posture. Jerome Powell conducts policy based on incoming data. He is clearly wary of forecasts that predict an overheating US economy over the next years. An overheating economy would be reflected in 7% to 8% nominal growth over 2021-2022, inflation readings well north of 3.00% and unemployment that would fall back to ‘full potential’ estimates around 4% by H1 2022. Difficult to counter argue such a sanguine outcome the moment Biden’s USD 1.9 trillion relief package passed in the Senate over the weekend. The House will vote in favour this week and economists will start to run their models in order to reveal the path ahead. However, as nice as the above figures read, an overheating economy will carry the seeds of its demise. First, the FED might be pushed to intervene, as long-term interest rates rise in a disorderly manner. The spectre of yield curve control becomes visible. Yield curve control at the 3-year to 5-year point might be bestowed with credibility. Capping 10-year to 30-year rates might be a bridge too far. In a scenario of an overheating economy there are no good outcomes. The outcomes will be positive over the very short-term but might destabilise the collaborative fiscal-monetary model longer-term. That is why the Biden administration should become more vocal on the type of taxation that will counter the current government spending spree and accelerate indebtedness. If the aggressive pro-cyclical fiscal-monetary policy is not reined in, the US economy might be struck by an ugly boom-bust set of events.

    • On this side of the Atlantic, we act almost completely opposite to the US. European monetary policy is, by and large, fully in the lead to soothe the impact of the pandemic. The EU-wide fiscal effort and strategy pales against the US’ fiscal largesse. Across EU countries and on an EU level, policy focussed on long-term initiatives that should boost EU competitiveness, protect current employment and lead in the climate-change related economic transition. The path taken by the EU will not lead to upside surprises in growth, inflation nor vibrant employment conditions over 2021-2023. US exceptionalism is here to stay. The Cares Act (USD 2 trillion) in March 2020 + the December 2020 USD 0.9 trillion Trump relief bill + the Biden March 2021 USD 1.9 trillion makes for a 12-month fiscal impulse of USD 4.8 trillion equivalent to EUR 4 trillion. The Next Generation EU recovery fund measures EUR 750 billion. The US impulse outpaces the EU effort by a factor of 5+. The EU has work to do. The current European Growth & Stability pact is not fit for purpose. The EU is not in danger of overheating, on the contrary. If the US can still prevent an overheating by increasing corporate taxation and taxation for the top 10% thus avoiding being trapped between a rock and a hard place, the EU is not even close to reaching that point. It is still debating the effectiveness of its institutional architecture. It is a breeding ground for populism to foster. Defining electoral moments in Germany in September, followed by France in the spring of 2022, will probably paralyse EU policy progress.

    • In the meantime, bond investors are definitely between a rock and a hard place. Why? Excessive reflation efforts might lift inflation uncomfortably high and lead to a disorderly sell-off in long-term rates. That would increase the pain for most bond portfolios that run average duration exposures. Most developed market government bond fund managers run a duration profile between 7.5 to 9 years. Investment grade (IG) corporate bond managers run a duration profile between 4.5 to 6 years. Emerging market government bond managers face potential worries concerning rising credit risk when US rates continue their ascent. High yield credit managers face a similar fate, but might resist for longer backed by positive growth momentum. At the same moment, participants are all aware of the elephant in the room. Central banks are indeed the largest buyer of last resort. They are also by far the largest holders. Central banks have ample instruments within their toolbox to resist a disorderly rise in rates. Flexibility is the word most bond managers dread. The FED could show flexibility and announce potential maturity extension operations using the argument of restoring proper market functioning. The FED could simply increase the purchase amount for US Treasuries whilst reducing mortgage backed security purchases, keeping the current USD 120 billion a month duration absorption unchanged. They could refrain from tapering under a scenario that incoming data disappoints! As consensus economic indicator projections are rising, the probability of negative surprises increases. The QE intentions of the ECB are transparent. Yes, they will consume the full PEPP envelope. The ECB will purchase the full amount of EUR 1.85 trillion by March 2022. That lifts weekly ECB purchase amounts to about EUR 20 billion per week. So, bond investors that position for higher rates by reducing their interest rate sensitivity are running the risk of a whiplash, as increased efforts by FED and the ECB to suppress long-term rates gets traction. 10-year, 30-year rates could easily drop by 25bp, lifting the spirits of bond fund managers with average- to long-duration exposures and hurting the low- or underweight-duration managers.

    • So, over the short-term, bond investors and managers are not satisfied as soon as rates run higher and their drawdown deepens. On the positive side, their expected return expectations are rising. Nonetheless, everyone is focussed on the short-term pain. On the flip side, bond managers that have reduced interest rate sensitivity or invest in more illiquid hybrid/subordinated bond instruments (with less rate sensitivity for the moment) lead the pack. Still, they are aware that a credible pushback from central banks could hurt. Another negative lies in the fact that a successful, central-bank-induced suppression of long-term rates would keep long-term return expectations well below inflation. The ultimate winner of successful financial repression will be governments. The question remains whether central banks can call the bluff of a growing pack of bond sellers. On Friday morning, the Bank of Japan called the markets’ bluff and repeated their firm stance on current yield curve control policies. Japanese long-term rates dropped. Let’s see if any follow through can be expected.


    • The brunt of the persistent bond sell-off in US rates felt on the 10-year point over the past week. We closed 16bp higher at 1.57%. The 10- to 30-year rate differential flattened for a second week in a row. This time by 2bp to close at 73bp for a 30-year rate that finished at 2.30%, up 14bp. The US yield curve up to 5-years resisted well. Inflation-linked bonds defended their ground with style. 10-year inflation expectations increased by 8.5bp to finish at 2.235%, almost breaking the highs of 2.245% reached on February 26. Still, real rates backed up by 7.5bp to close at -0.665%. 3- to 5-year inflation expectations fluctuate around 2.5%, reflecting a cyclical inflation lift. Such readings fit like a glove with the Flexible Average Inflation Targeting policy adopted by the FED. What struck me during the Powell speech at the Wall Street Journal Jobs Summit was his acknowledgement that the FED conducts policy based on actual progress, not on forecasted progress.

    • European Government Bonds (EGB’s) went counter to the US. 10-year German bund rates dropped 4bp, closing at -0.30%. Spain and Portugal followed well and closed 3bp and 2bp lower at +0.39% and +0.29% respectively. Italian 10-year rates dropped by 1bp finishing at +0.75%. The market got solid support from ECB purchase programs. All eyes are on the ECB meeting next Thursday, March 11. Expect a very dovish set of ECB messages.

    • European IG corporate bonds staged a comeback over the week. Regaining 20bp in performance brings the asset class back to a correct -0.90% year-to-date (YTD) result. IG spreads were not impressed at all by the increased rate volatility. A similar attitude was met within European high yield (HY) markets as they added 11bp over the week. YTD, European HY rakes in a solid +1.10%.

    • The yield of the emerging markets local currency index (GBI-EM) rose around 50bp YTD, and sits around 4.75% today. Measured against 10y US rates, which moved from 0.90% to around 1.60%, spreads have contracted around 20bp. In Q4 2020, we wrote that the rates part of emerging markets would not be the main driver of performance going forward. Many emerging market central banks have lowered rates at an unprecedented pace and are near the end of the easing cycle. On top, historical low yields boost issuance in the longer end of the curve, as many issuers want to lock in low rates for as long as possible.

    • On currencies, we are more optimistic and we continue to be, despite recent weakness and recent increased volatility. We expect countries to start normalising monetary policies (Ukraine, Brazil, Peru, Czech Republic), which will support their currencies. The positive global growth outlook next to higher commodity prices will be positive drivers for emerging market FX going forward. One has to take the ‘bumpy road conditions’ as part of the journey.

    • This week’s price action in Brazil was all about fears that the government would remove the Bolsa Familia social program from the spending cap rule to open room for extra spending. The currency erased losses on Wednesday afternoon, as Paulo Guedes convinced President Bolsonaro to pressure lawmakers to keep the Bolsa Familia within the spending limit. The outcome is positive for a country with one of the highest debt levels in emerging markets. It meets three conditions : a) putting a cap on how much the government can spend, (which is nearly BRL 45 billion), b) keeping the fiscal offsets, c) imposing a victory from the economic team over the more spending-prone side of government.

    • At the National People’s Congress (NPC), the Chinese government surprised somewhat by announcing a conservative GDP growth target of ‘above 6%’ for 2021 – below most economist forecasts – and a budget deficit of 3.2%. The CPI target has been reduced from around 3.5% to 3.0%. The balance of payments objective is to reach equilibrium. The emphasis has been put on employment, with a target creation of 11 million in new gross urban jobs and an unemployment rate goal of 5.5%. The monetary policy will be kept ‘prudent’, ‘flexible’ and ‘targeted’, at a ‘reasonable’ and ‘appropriate’ level. Policymakers have added remarks on the need to balance support to the economic recovery with long-term sustainability goals. In that respect they will hold the macro leverage ratio stable i.e. control credit growth. More specifically, money supply and aggregate financing should stay in line with nominal economic growth. As a reminder, Total Social Financing has reached a record level last year at 280% of GDP. So far, Chinese local rates have been immune from moves in US rates.


Bond investors face a complex macro-economic equation that is difficult to solve. Fiscal policy profligacy puts long-term rates under pressure. At the same time, fiscal authorities require stable and low funding costs in order to achieve long-term societal objectives. Supposedly, the bond vigilantes have awakened from a 40-year long hibernation. I highly question such a statement. Bond vigilantes can operate successfully in free markets. Today markets are not free. End of discussion. The arbiter in this power play remains the central bank institution. “Never fight the FED…or the ECB…or the Bank of Japan” has been a timeless adagio. Will this time be different?

The decision on a micro-portfolio level regarding the correct interest rate duration profile is similarly complex. This complexity is due to the uneven pay-off one faces. Central banks can remain quiet, roll-out current policy i.e. adopt a status quo approach, or they can react. If they react, it will not be on the demand of the market but required by fiscal policy considerations. The common-sense answer to the duration call that pops up is: ‘Adopt a neutral duration stance’… This ‘neutral duration’ expression must be read in the context of the above reasoning. I fully respect all bond strategies that can shine and resist through a bond correction of which the length is impossible to predict.


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