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STATE OF AFFAIRS
We are not pointing to the concept of market timing. Newspapers are filled with such predictions every day. We refer to the episode that monetary and fiscal policy will impact global economic growth conditions for real. The global policy response to the pandemic over 2020 was geared to support and stabilise market functioning as well as support employment (and demand) through direct and indirect government programs. From sending pay-checks to providing interest payment delays, from partial to complete government guarantees when rolling over funding requirements, governments around the world have focussed on buffering the 2020 impact of the pandemic. Actual cooperation between monetary and fiscal bodies since March has been geared to stop the bleeding induced by partial or full lockdowns. It’s recovery ammunition that is passing through the system. The successful start of the SURE (Support to mitigate Unemployment Risks in an Emergency) funding program has been a case in point this week.
Market participants will need to assess when subsidy policy will morph into productive investment policy. We predict that such policies will not prevail over 2021. We require wide-spread vaccination allowing public and private sectors to normalise operations. Until such time, financial conditions will be maintained at extremely accommodative levels. Net bond supply will be kept at a minimum, as central bank flexibility will strengthen asset purchase programs in order to absorb government borrowing requirements. The argument that rising US rates over the past week were due to a bipartisan compromise over a fourth fiscal support program is of poor quality. We reckon that sell-side positioning, market-maker strength and shorting activity by fast hedge fund money enabled them to push up rates without encountering much real money counterweight.
Yes, a steady increase of inflation expectations is warranted, given the uncertainty on when restrained capacity will be charged to end consumers. However, a steady increase in real term premia is not in place at this juncture. The quality of fiscal policy initiatives aimed at productive investments in public infrastructure, energy transition, or education will signal a potential for sustainable and inclusive growth acceleration. About 6 to 18 months before central banks decide to tighten policy rates, real short and long-term rates might turn the corner and move higher. Given strong forward guidance that policy rates will remain unchanged over the next 3+ (FED) to 5+ (ECB) years, a sustained bear steepening is not evident. Make no mistake, market participants will closely follow this track that leads to inclusive real economic growth. Timing the inflection point is of paramount importance. The longer it takes for multilateral cooperation to recover, allowing global trade to develop, the longer we will live with nominal rates around current or even lower levels. So, discuss, study and look through the noise of the day in order to detect real proof that might set us up for upside normalisation of long-term interest rates. Expecting such an outcome today is premature.
As Fed governors roll over each other trying to explain how well US monetary policy is conducted, we got confronted with a chilling bear steepening over the past week. The US Treasury market is not going into hibernation. Over October, the US Treasury bond volatility measure (MOVE index) swiftly moved from historic lows from around 40 basis points (bp) to just below 60bp. US 5-year rates increased by 10bp towards 0.37%. US 10-year rates moved up 17bp to 84bp since October 1, whereas US 30-year rates offer 19bp more yield at 1.64%. The 5-year 30-year rate differential closed at 1.26%, about 7bp away from its 20-year average. As we wrote a couple of weeks ago, expect increasing investor interest as 10s move towards 0.90% and 30s test 1.75% levels. Real term premia as well as inflation expectations are rising tentatively. This market participant expects more potential for higher inflation expectations. A rise in real term premia on the back of fiscal profligacy might be misplaced, as the FED will prevent premature tightening of financial conditions. The FED meeting on November 5, might lead to an increase in large scale asset purchases alongside a preference for longer maturities.
EMU government bonds behaved stubbornly and focused on expectations for continued large scale asset purchases by the ECB till end of 2021. The sell-off in US rates trickled down across EMU rates. However, German 10-year rates only backed up by 5bp towards -58bp, whereas Italian, Spanish and Portuguese 10-year rates added 10bp, 7bp and 6bp respectively towards 76bp, 19bp and 17bp respectively. Standard and Poor’s revised the sovereign outlook for Italy towards ‘stable’ from ‘negative’, whilst re-affirming long and short-term ratings at BBB/A-2. 10-year Bund/BTP spread closed the week at 1.33%. One should not be surprised to see a test towards 1.25% spread over next week.
European investment grade (IG) corporate bonds are very resilient. Over the week the Iboxx corporate index conceded only 9bp of performance, versus a retracement of 65bp for the above-mentioned EMU government bond sector. The IG corporate bond buffer in action. Institutional investors are craving new supply as hampered by the earning season black out period. Cash levels are increasing by the day. For IG credit spreads to rise meaningfully, the pandemic will need to worsen. The current, already worrisome, scarring will need to worsen in order to push credit risk premia higher.
The European high yield (HY) sector countered the small rate pressure in style, adding 31bp to the performance tally. With a year-to-date result at -1.28%, we have returned to the early days of March. Full recovery over the next two months is a distinct possibility, given an attractive spread around 4.50% for a yield of around 4.00%. Compared to IG corporate bonds, the sector has more buffer potential if more rate-pressuring weeks are ahead of us.
Emerging market (EM) spreads moved sideways (again) last week. Local Currency spreads (GBI-EM), traded at 3.78% (-4bp). Hard Currency IG is now at 2.19% (+8bp) and Broad Hard Currency (EMBIG) at 4.44% (+10bp). Sub-Saharan Africa spreads in Hard Currency tightened to 7.14% (-4bp).
EM currencies posted a negative weekly performance when measured in EUR (-0.5%). Chilean Peso (+1.4% in EUR terms), South-African Rand (+1.20%) and Colombian Peso (+1.0%) are the winners; Argentine Peso (-1.4% in EUR terms), Peruvian Sol (-1.3%) and Thai Baht (-1.2%) the biggest losers.
Looking at full performances on a country level Month-to-Date, Mexico (+3.6%), South-Africa (+2.3%) and Indonesia (+2.1%) have been the best performers. Turkey (-2.8%), Peru (-1.2%) and Czech Republic (-1%) the worst performers.
Most countries in Latin America will be unable to return to their pre-pandemic growth levels until 2023, according to the International Monetary Fund. Looking at the number of cases, Peru has been the worst hit, with close to 25.000 per million habitants. The Central Bank showed its commitment and moved into a strong expansionary stance, by lowering rates to 0.25%, amongst the lowest rates in EM. The economy has recovered somewhat faster than expected but GDP will still contract by around 13% in 2020, followed by a 10% expansion in 2021. On the fiscal side, the country, which has the lowest Debt to GDP ratio in Latin America (38.4%), will face the challenge of increasing tax revenues soon. In recent weeks, Peruvian bonds have performed poorly as a result of congressional approval of a bill, allowing a second round of withdrawals from private pension accounts. The central bank warned that the bill will push up rates and harm the economic recovery. Indeed, when pension managers have to pay out an estimated USD 4 billion, they will sell domestic bonds and make foreign investors, who hold 53.9% of Soberanos, anxious. We believe that the bulk of re-pricing is behind us and that PERUGB are attractive, especially in the 15-20y part of the curve.
The Turkish Central Bank’s policy decision disappointed the market. Indeed, the Central Bank of the Republic of Turkey kept its one-week repo rate unchanged at 10.25%, but instead raised the upper-bound of its interest-rate corridor to 14.75%, effectively increasing the cost of lira funding. This “back-door” tightening will question the central bank’s credibility and is unlikely to curb the volatility in the TRY. Also, Turkey’s sovereign wealth fund postponed its Eurobond sale due to adverse market conditions, which would have resulted in deteriorated funding conditions.
South-Africa posted a good weekly performance and the weekly local bond auction received very strong demand. It seems that local buyers have stepped up and helped SAGB s rally. For instance, the bond maturing in 2035 tightened by 40bp, since the highs at the beginning of October. Our attention rests on the crucially important budget statement (MTBPS) on October 28. The budget will have the hard task to be market friendly, while accommodating for the economic measures announced by President Ramaphosa last week.
On the external debt front, Sri Lanka’s Eurobonds complex has suffered this week. Selling flows caught dealers by surprise, with the front end underperforming heavily. Thursday’s news on a constitutional amendment to concentrate more power into the hands of the executive, added more worries. Sri Lanka faces a complicated economic situation. The country is tourism-dependent and flirts with a 100% debt to GDP ratio. We still believe the country will have to restructure its outstanding Eurobonds at some point.
Distinguishing among the drivers of change for policy rates and long-term rates is an essential ingredient in the recipe that can lead to successful bond investing.
The current episode is characterised by stimulus measures that soften the impact of the deep recession and allows for a protracted recovery.
In order to assess value or express richness in core rates we have to gauge what kind of economic policy path developed and developing countries will follow in order to lift growth potential. Today the situation is blurred.