DPAM Blog

STATE OF AFFAIRS

• • Complacency by market participants always occurs in hindsight. As a result, defining the factors that make up complacency is a daunting task. This challenge becomes even more complex as we travel through the initial, early economic recovery phase, reflected across multi-decade highs in soft, survey-based indicators. PMI indices (and sub-indices) are leading the charge. Complacency precedes drawdowns. In this letter we touch upon some themes that might trigger broad-based market stress and describe reaction functions across bond sectors and resulting return impact. The themes that are most relevant circle around:

     

    1. Inflation scares and frontloading of lift-off dates for central bank policy rates

    2. Changes in peak-optimism that might appear through negative adjustments in growth prospects or actual data disappointments on lofty growth consensus estimates. Both will impact many narratives

    3. Tapering paths across multiple central bank asset purchase programs

    4. Political (election calendars) and geo-political stress (Middle East & China leading)

    5. Pandemic uncertainty

     

    I pull on the first three themes as triggers of changing complacency. US ‘Real politik’ on the international front is required, with the Biden administration giving priority to domestic issues. Vaccination is progressing. Uncertainty surrounding the long-term trajectory is supportive of defensive, qualitative investment flows but remains complex to measure.

• • Since November 2020, when we welcomed a new US president, and, more importantly, effective vaccine solutions, DM long-term rates have been trending higher. The US 10-year rates adjustment, and concurrent US yield curve steepening, accelerated through February and March, but since then both have been consolidating. US 10-year rates have been able to consolidate between 1.50% and 1.75%, notwithstanding the confirmation of inflationary flares across core CPI & PCE series showing a 3% handle. EU 10-year rates, highly resistant over Q1 2021, succumbed to the pressure ‘leaking’ higher over Q2, with German 10-year rates touching -0.10% mid-May, ending the month near -0.20%. YoY Eurozone inflation data will jump towards 2.3%-2.5%, reflecting base effects and supply bottleneck price pressures across goods and commodities. The structural versus cyclical inflation debate will rage on over 2021 into 2022. Fact is that the market today expects a US and EU average longer-term inflation of 2.42% and 1.60% respectively.

• • Complacency risk in rates translates into the narrative that we have reached appropriate levels in long-term rates as we pass through a period of peak growth optimism, peak PMI readings and peak inflationary data points. It also counts on steady US monetary policy that will intelligently and slowly taper asset purchases and not frontload any interest rate hiking cycle before H2 2023 as maximum employment conditions might only be reached by 2024-2025. At current levels in US rates, I estimate that investors can be complacent and that the probability for a similar Q1 2021 push higher, driving US 10-year rates towards 2.25%-2.50%, is low. Such a statement is driven by decent expected returns in US Treasuries versus long-term return expectations across publicly traded risk assets. The ‘third mandate’ of the FED is to preserve stability in financial markets. That is not saying that the FED will provide the market with backstops the moment adjustments crystallise. Effectively, the FED has welcomed the rate normalisation over the past 6 months. Sustained accommodative monetary policies have pushed investors up the risk ladder across investment grade (IG), high yield (HY) corporate bonds, convertible bonds and equity. I will not comment on any specific equity valuation factors, as I want to respect my rule of thumb not to comment on a sector that doesn’t belong to my field of expertise. However, bond investors cannot neglect the equity sector as flight-to-quality flows have not disappeared. The narrative tells us that bonds cannot offset any correction in risk assets anymore. I guess such a point, in hindsight, was relevant over 2020 and early 2021. At current rate levels across the US Treasuries, quality EM sovereign and specific EMU government bonds, the picture has changed. With complacency risk at the lower end, I assess that complacency risk on spread product have grown.

• • Fact is that spread sectors might run into difficulties the moment US 10-year rates would disorderly rise another 60bp to 90bp or EU rates, taking a similar beta, adding another 30bp to 45bp. Such a move might cause a more pronounced adjustment in US equity markets, with negative spread-widening spill-over effects. Financial conditions across financial and non-financial corporates would bite. Corporate loans on banks’ balance sheets, possibly confronted with a combined loss of moratoria and or government guarantees, would deteriorate, leading to an increase of banks’ cost of risk. Banks would tighten loan standards at the worst possible time.

• • On the other hand, from a risk-adjusted expected-return perspective, government bonds might become the best choice of lesser evils. With rates consolidating at current levels, or at best dropping, handsome carry and roll-down returns or correct total returns might be in the offing. Consensus makes most sense on the call that policy rates will remain at the negative or zero-lower bound for at least another 2 years. So, the moment peak positivism makes room for less buoyant growth surprises, credit spreads might become victim to increased profit taking flows. Subpar liquidity conditions, given prudent risk control across sell-side market makers next to the prospect of less supportive central bank 2022 QE programs, might turn current complacency into more active hedging or rotation flows towards DM and EM government rates. Positioning in credit has indeed grown from strength to strength as the narrative of central banks as the lender of last resort for corporates gained traction. In the US, the FED ended their involvement across various corporate and banking relief programs over Q4 2020 and Q1 2021. Complacency risk are growing in the European IG credit sector, and, by extension, HY sector (a HY sector that saw stubborn and continues interest from yield-searching retail and institutional investors). Investors that might have or are in the process of rotating out of the defensive rates sector at the worst possible moment.