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STATE OF AFFAIRS
Rate and credit markets have clinched onto a consolidation pattern over the month of April. The fate of credit markets lies in the hands of rate markets. Credit spreads enjoy goldilocks conditions. Growth is recovering, central bank asset purchase programs remain in highest gear, whilst most governments maintain or increase support and/or guarantees towards the hardest hit sectors. The underlying cause for such consolidation lies in a reckoning by the financial community that this pandemic is an extremely complex, global health crisis. Vaccination by itself will not wipe-out COVID-19. A proliferation of new strains is the main unknown-unknown factor. Even more worryingly, reaching herd immunity has been moved aside by political leadership as a condition of normalisation. Supposedly the population at large has depleted its motivation to respect behavioural rules or standing pandemic legislation. A growing number of politicians in power even try to increase their popularity by promising an open society by summer. Against a backdrop of a rising 7-day moving average of global infections making new highs this week, enthusiasm in financial markets is waning. It is effectively this dawning of ‘We’re not there yet…on the contrary!’ that starts to get translated in rate markets. As short-term anxiety might rise, it feels like the opportune moment to look at pricing and valuations by December 2023. Even the most pessimistic out there should hope for a global economy that is no longer affected by COVID-19 related confinements and restrictions.
US FED fund policy rates is our first stop. Last Friday, 90-day Eurodollar futures for December 2023 closed at 98.96. By the end of 2023, the market has fully priced 3 FED policy rate hikes sitting at 0.75 – 1.00%. Consensus is that the FED starts tapering its asset purchase program in early 2022. A USD 10 billion-a-month reduction would run down the current program in 12 months. Indeed, by spring 2023, the market has priced at a 100% certainty a FED fund rate of 0.25%-0.50% initiating lift-off. The Eurodollar futures contract table informs us that the FED would opt for a protracted policy normalisation cycle, raising rates 3 times over 2023. It would effectively take another 2 years, to around Q3-Q4 2025, to reach 1.75%-2.00%. The ECB lift-off would take place about a year after the FED’s. However, pricing is not conclusive. The ECB has already warned that they would not be inspired by the US central bank. I see no reason to counter that at this juncture. The market has calibrated both central bank reaction functions well. Expect the FED to confirm these expectations by Wednesday, April 28.
The ‘December 2023’ forward rate for the 10-year US Treasury bond sits at 2.25%. Once again, this pricing coincides with the orderly rate adjustments that the FED targets. The US 10-year rate by December 2025 is valued at 2.55%. At that moment a policy rate just below 2.00% should have contained an overshoot of inflation expectations, allowing 10-year real rates into positive territory. A scenario where current 10-year inflation expectations at 2.35% prevails would translate to +0.20% in 10-years US real rates. The German 10-year bund is expected to trade around +0.10% by December 2023. Such an outcome would drag global bond markets away from the ‘there is no alternative’ narrative. By the end of 2025, the market prices 10-year Bunds at +0.31%. Such a valuation would send the German reference rate into the +0.25% to +0.50% range that marked conditions between 2015 and 2018.
In FX markets, the above interest rate paths define forward exchange rate levels. The EURUSD strengthened towards 1.2097 last Friday. The US trading session took the main pair well above its 100-day moving average of 1.2056. In forward space, by the end of December 2023 the EURUSD changes hands today at 1.2425. I repeat that every headline call by market commentators should be interpreted against what is priced and expected today. By December 2025, the EURUSD trades at 1.2865. These levels will prevail if interest rate differentials between Europe and the US track interest rate forwards as priced today. The USD, still the uncontested reserve currency, enjoys many other diversification benefits within portfolio construction. Together with the CHF and the JPY, it remains the refuge currency of choice the moment risk-off episodes erupt.
With survey-based economic indicators hitting decade highs in the US (PMI, ISM…), bond markets continued to cover shorts, landing the 10-year US rate at 1.56% or about 2bp lower than the previous weeks’ close. One could say that bond investors have started to doubt the current narrative that all will be well by summer. The US doubling-taxation story on investments by the wealthy that unfolded, did not impress bullish equity markets. Guess that being too specific is not a well-chosen communication strategy. The overall result, though, will be the same. Expect taxation to be part of the comprehensive US solution to catapult the US into a position of world leadership. Again. World leadership in climate response as well as in policing other military and economic powers like Russia and China. It all took place over the past week! The geopolitical strategy rolled out in front of us by the Biden administration is, quite honestly, impressive. Threatening Rouble government bond investors whilst at the same time cornering Chinese president Xi with respect to reduction targets of GHG (greenhouse gas) emissions is a rare example of statesmanship. It will have a price tag of course. A price tag that will require intense collaboration between Yellen as Treasury Secretary and the FED chair. Do not expect any undue tightening of financial conditions that would interrupt or distort those longer-term goals.
European Government Bonds (EGB’s) leaked another 9bp in performance. Year-to-date EMU government bonds have retreated 2.90%. The ECB meeting was effectively a non-event and was mostly setting the stage for the June meeting. The higher intensity of PEPP purchases is stabilising EMU rates. The fact that, on balance, bank lending standards are tightening is not that surprising. Banks are enabled to push forward large sections of their loanbooks given moratoria that are extended or guarantees that protect balance sheets of small and medium-sized enterprises. Expect intra-EMU rate compression to be the biggest benefactor of PEPP frontloading.
The investment grade (IG) corporate bond sector showed a flat result over the week and posted a -0.75% year-to-date result. The 2021 performance gap with EMU government bonds is widening. However, if we take end of 2019 as our starting date, we observe the following photofinish result : the two main European bond sectors have returned 2.10% and 2.14% for EMU government bonds and IG corporates respectively.
European high yield (HY) witnessed some profit taking, dropping 14bp over the week. No reason to panic for the moment with a +2.06% year-to-date result. Primary markets will reopen as soon as peak earning season results draw to an end. HY spreads are well supported by an institutional bid that counts on government backstops and central bank largesse.
Local currency emerging markets (EM) moved sideways this week. The yield of the EM local currency index (GBI-EM) ended at 4.86% (-2bp), whilst the EM Currency Index remained more or less unchanged just below the 57 handle.
Currency volatility remained just below the 10 handle. Brazilian Real (+1.95% in EUR terms), Taiwan Dollar (+0.30) and Russian Rouble (+0.25%) posted the highest weekly returns. The Peruvian Sol (-4.20% in EUR terms), Turkish Lira (-4.00%) and Kenyan Shilling (-1.90%) were the laggards.
The Columbian government presented the long-awaited fiscal reform before congress. The plan should raise at least around 1.4% to 1.5% of GDP in revenues. Under-delivery increases the risk of downgrades by credit agencies, jeopardising the investment grade rating of Colombia. Indeed, the on-going risk of further deterioration in Colombia’s fiscal accounts is the main raison why S&P maintained a negative outlook, but affirmed the BBB- rating last Thursday. The main goal of the fiscal reform is to optimise the fiscal policy by consolidating an equal social infrastructure under a fiscal sustainability framework. The fiscal reform will cover three areas: i) The Fiscal Rule, ii) Social programs, increasing expenditures by around 1% of GDP and iii) Redistribution of fiscal burdens (tax reform), raising income by about 2.5% of GDP.
Peruvian 10-year government rates climbed 50bp in a week (and around 200bp YTD) and closed around 5.40%. The April 11 Presidential and congressional election showed a major shift from the right to the left, with Pedro Castillo of the Partido Politico Nacional Peru Libre the unexpected winner. His party proposes a number of market ‘unfriendly’ policies, such as establishing a new constitution with the government as the redistributor of wealth, calls to nationalise assets (mines) as well as the renegotiation of foreign debt. Such proceeds would be reinvested in social projects. The unicameral congress of Peru will be extremely fragmented and despite the move to the left, all far left parties together, hold 37/130 seats or 28%. This makes the implementation of radical proposals very difficult. Pedro Castillo will face centrist-right Keiko Fujimori in the second round, which is to be held on June 6. The uncertainty remains very high with neither candidate receiving more than 20% of the votes in the first round and the potential to shift in both directions in the run-off to the second round. Notwithstanding the value that has been created in recent weeks, the sizeable foreign ownership of local bonds (around 48%) and the binary election outcome advocate for a cautious stance.
Bond investors are kind off addicted to the movie ‘Back to the future’. We always look back into the past as well as into the future for guidance. Today’s letter looked towards December 2023 and found a world that would fit the picture desired by central bankers around the globe.
Maybe the market starts to accept and price the omnipotence exerted by central banks on rates, credit and FX markets.
As real economies are on the verge of reopening, financial markets are on the verge of receiving higher control. Control not only by central banks, but also by their close government friends.