Beyond lift-off and QE

By Peter De Coensel,
CIO Fixed Income at DPAM



    • Using the word anxiety was underscoring the panic that took hold of global bond markets last Thursday. Apparently, the trigger was related to the poor 7-year US Treasury auction. Investors received paper at 1.195%…when, just before closing the bidding process, the 7-year UST traded at 1.15%. The auction ‘tailed’ by 4bp, as expressed by the dealer community. Unseen, as in unusual and story-making. The market structure supposedly might get weaker and weaker. Fact is that an auction can tail or stop short. The latter occurs when the Treasury is able to issue below the rate that prevails just before the new issue process is closed. As a former market-maker, I remember that auctions come in waves. Over the past week we got a painful wave. But others will come in, gently followed by a smile instead of a scary face. By the end of the week, the rate scare turned into a scramble, as 10-year notes made a volte-face, closing at 1.40% after hitting 1.60% the day before and trying to find an equilibrium at 1.50%. Bond investors must have smelled value late on Friday. Especially at the long end of the curve, where we saw high interest in 30-year Treasuries. Indeed, the 10 to 30-year part of the yield curve flattened a solid 5bp over the week! What is going on here? I will take you beyond the moment the FED will start to hike rates as well as future tinkering with their QE purchase program. This means we are not looking to mid-2023, when markets call for a first FED hike towards 0.25%-0.50%. We are also not interested in end 2021, or early 2022, when most sell-side strategist see the FED reducing monthly asset purchases from the current USD120 billion a month pace. Let’s put all of the above events aside and reflect on where the bond market prices the US yield curve in March 2026.

    • We take the current coupon US Treasury yield curve in order to include term risk premium and inflation risk premium effects. The US yield curve plots as follows: 1-month rate 0.03%, 1-year rate 0.07%, 2-year rate 0.13%, 5-year rate 0.73%, 10-year rate 1.40%, 30-year rate 2.15%. Now let’s look at this curve 5 year forward: 1-month rate 2.07%, 1-year rate 2.15%, 2-year rate 2.15%, 5-year rate 2.12%, 10-year rate 2.42% and 30-year rate 2.48%. The key messages to distil are threefold. First and foremost, the bond market prices in a FED tightening cycle of between 7 and 8 policy rate hikes. The narrative that the FED is married to zero-interest-policy is fluked. One can also expect that moment that the FED start hiking somewhere over 2023-2024 that they might hike by about 1.00% a year. Let’s, for argument’s sake, say that they hike to 1.75%-2.00%. That would take the FED about 50bp below their current long-term 2.50% policy rate prediction. Food for thought, but the pandemic has altered the employment equation as well as the globalisation equation. Both might compress the terminal rate. We will discuss these structural factors in another letter. Secondly, we observe a rather flat yield curve 5-year out. At the short-end up to 2-years out, we pencil in a 2.15% rate. The optimist reads this as not bad for a risk-free alternative. The pessimist will detract the inflation rate that prevails in 2026. Looking at 5-year market-based inflation expectations as priced through US TIPS (inflation linked bonds) we estimate to have a 2.40% average CPI rate over the next 5 years. So that would confront you with a -0.25% real rate investment. The yield curve shape reveals another peculiarity. Indeed, the attentive reader will have noticed that the forward yield curve inverts at the 5-year point, plotting 2.12%. This means that the weighted assessment of all participants informs us that a tightening cycle towards 2.00% might already have the potential to hurt economic growth, employment conditions or suppress inflation. The third message is that the 10-year and 30-year rates almost meet! With 10-year rates at 2.42% versus 30-year rates at 2.48%, the 10/30-year interest rate differential collapsed towards 6bp. Friday we closed the 10/30-year rate differential at 75bp. To monitor: did we witness the high point in the steepening tension between 10 and 30-year rates touching a level of 87bp last Thursday? Bear in mind that, over the last 44 years, we have observed three very brief episodes where this all-important indicator went above 100bp. If so, investing in 30-year US Treasuries today, or 30-year high quality corporates could be very rewarding.

    • By now, everyone sits with the question “But how about the situation in Europe?” I decided to take the core German Bund yield curve, as this curve is and will be recognised as the true risk-free rate curve for years to come. Even if the Next Generation EU recovery fund will be the catalyst for the future EU risk-free yield curve, too many assumptions and realisations are required. The key one, of course, represented by a credible EU fiscal policy union. We will go through the same drill as above. The German yield curve plots as follows: 3-month rate -0.623%, 1-year rate -0.624%, 2-year rate-0.668%, 5-year rate: -0.57%, 10-year rate -0.26% and 30-year rate 0.19%. The German yield curve 5-year forward: 3-month rate -0.33%, 1-year rate -0.31%, 2-year rate -0.21%, 5-year rate 0.06%, 10-year rate 0.22% and 30-year rate 0.38%. The three messages that are revealed here are inspiring. First, the market expects the ECB to act very slowly and late in starting a policy rate tightening cycle. If they use hiking increments of 10bp, we might expect two hikes by 2026. Effectively this reads as if we should attach a certain probability of complete status quo by the ECB over the next 5 years. Second, the curve also bear flattens, as was the case for the US yield curve above. However, the amplitude of the German bear flattening is lower than is the case for the US. This points to the uniqueness or strong status that the German sovereign yield curve enjoys. It is the flight-to-safety bond market par excellence. Investors see the German government bond curve as an insurance instrument. That’s why paying up…by accepting negative returns is part of the insurance package. Third are the levels of 10-year and 30-year German rates. Our thoughts dwell towards the situation of Japanese rates. Bearing in mind that Japanese policy rates froze around -0.10%, the 10-year JGB (Japanese Government Bond) at 0.15% versus +0.75% on the 30-year JGB marries well with ECB policy rates around -0.30% next to the above 0.22% and 0.38% on the German 10-year and 30-year point in 2026.


    • The US yield curve bear flattened aggressively over the past week. As the market calls for this modus over the next 5 years, expect more weeks with such an opening. The brunt of the sell-off occurred in the 5 to 7-year maturity bucket. 5-year rates increased by 15bp, closing at 0.73%, 7-year rates up 15bp as well, closing at 1.12%. 10-year rates only added 6bp to close at 1.40%. The big surprise, so to speak, was delivered by the 30-year point that added a mere 2bp closing at 2.15%. Inflation-linked bonds behaved in a similar fashion. The real rate curve bear flattened in sync. Inflation expectations showed resilience.

    • The European Government Bond index lost more ground over the last week of the month. February posted four negative return weeks in a row. Not counting March 2020, we must go back to the infamous Bund VaR shock episode between late April to late June 2015 to find a worse total return month. So, over February, EMU sovereigns dropped 1.89% and have retreated by 2.57% since January 1. At the end of the day, 10-year bunds eased an acceptable 5bp, ending at -0.26%. Italian 10-year rates ill-digested the increased volatility and increased by 14bp to finish at 0.76%. Spain and Portugal resisted a lot better and rose by 7bp and 6bp respectively towards +0.42% and +0.31%.

    • European investment grade (IG) corporate bonds cracked under the spike in volatility. In general, spread product thrives in low-volatility market conditions. So, performance retreated another 40bp over the week to post a -1.10% result. Higher volatility also caught up to European HY, shedding 45bp over the week. Still, YtD they nicely hold onto gains at +1.01%. It is as if rate markets dominate the show and spread instruments watch the show go by.

    • Emerging market (EM) assets got rocked by the spike in US rate volatility. The JPM EMBIG for hard currency sovereign bonds dropped 1.60%, despite stable (+1bp) spreads versus US Treasuries. The JPM GBI-EM index lost 1.34% in USD terms with -0.96% coming from the local rates component. In EUR terms, the weekly performance was even more negative (-2.33%), given a resilient Euro. YtD the index drops 2.95%.

    • On the positive side, the yield of the local currency index rose by 19bps to 4.66%. The JPM EMCI index for EM currencies spot returns lost 1.61% in USD (-2.67% in EUR). Biggest losers were high beta markets like Turkey (-5.93% in EUR terms), Brazil (-2.56%), and Mexico (-2.47%). Flow wise, inflows returned to EM bonds funds after last week’s outflows, especially in local debt funds (USD 1.8 billion), while hard currency funds flows were almost flat. The primary market remains open for business with notably Serbia and Croatia deals in EUR attracting some decent interest (>EUR 3.2 billion and 6.4 billion respectively).

    • We entered the year with a bullish outlook on EMFX and more neutral stance on EM rates due to the strong duration gains of last year and low central bank rates. Clearly, US rate volatility has put EM rates under pressure. More recently, the rise in US real yields started to weigh on EMFX. However, focus on the positive medium-term global growth recovery picture that will support cyclical assets. It looks odd that EMFX in general and especially the FX of commodity-exporting countries have underperformed the rebound in global commodity prices. Meanwhile, when it could be attributable to a structural lower growth outlook in those countries, it doesn’t fit with the positive economic surprises in EM and the performance of equity markets of commodity-producing countries. A poorer management of COVID-19 could provide an explanation, and therefore it could look like an opportunity for future performance should this crisis wear off over H2 2021.

    • For now, we have to acknowledge that, paradoxically, both EM rates and EMFX have suffered due to the positive growth outlook in the US. We want to flag an interesting report issued by the IMF named “The Great Divergence”. They state that the pandemic “is not over anywhere until it is over everywhere. A coordinated effort to end the health crisis for all should accelerate vaccine availability for poorer countries” .

    • South Africa presented an investor-friendly budget on Wednesday, signalling a change in budgetary policy to focus on positive primary deficit targets in the future. Also, the figures released could lead to a reduced pace of weekly auctions. The good news was however anticipated and the huge rally of 40bps across the curve was short-lived. The volatility in US rates kicked in and yields ended the week at higher levels than they were before the budget.


Today, more than ever, we should question the relevance and importance of short-term success in financial markets. Success in calling the market 6-month or 12-months out, or success in making short-term profits. Financial markets seek unhealthy frontiers on both counts. The GFC of 2008-2009 was rooted in the excesses represented by structured bond solutions across mortgages and credit. Will the next financial crisis be rooted in the excesses represented by structured equity solutions, the likes that flourish through SPAC’s, niche ETF’s… with or without leverage?

Our venturing exercise looking out 5 years across core US and German yield curves invites investors to reflect, pause and improve decision-making in times when sentiment often takes over. The future will be challenging for bond investors, but not to the extent that escapism or running away from the asset class would offer more comfort. On the contrary.


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