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STATE OF AFFAIRS
As emerging markets (EM) central banks continue to cut policy rates, we can state that most developed markets (DM) central banks have reached their effective lower bounds. They have engaged in ‘enforced forward guidance’ by telling market participants that policy rates will be kept at the effective lower bound for years to come. The US FED has alluded to 2023. Market based indicators reveal that the ECB plans to keep its policy rates unchanged till 2026. Moreover, the global policy response reveals a clear cooperation between monetary and fiscal engagements. This cooperation will be reflected by persistent QE activity to allow governments to fund bloated deficits, and to provide credit easing to the corporate sector. The results of such potent mix have started to emerge.
DM government bond rates are on a secular convergence path. The combined size of asset purchase programs makes central banks dominant in duration absorption. The remaining government bond ‘free float’ is shrinking. The FED, the ECB and the Bank of England will hold 35% to 50% of outstanding government bonds under continued QE intervention. The direction is clear. Institutional investors are getting crowded out. We observe that the quest for quality government paper spreads globally. These past four months, the rate convergence on the 10 year point has been quite aggressive. The majority of DM markets have 10 years rates between -50bp and 100bp. We expect that this 150bp-range will continue to shrink. New Zealand and Australian 10 year government bonds are attractive at 92bp and 85bp respectively. With 10 year US Treasuries at 64bp and Canada at 50bp, global investors will continue to seek portfolio protection value. In comparison, strong EMU countries offer poor returns over similar investment horizons (-15bp for France and Belgium to -50bp for Germany and Switzerland). Outliers are Italy (1.28%), South Korea (1.30%), Poland (1.35%) or Hungary (2.05%): Countries mired in political uncertainty.
The EMU government bond sector can look back on a strong performance over the past three weeks. Its total return adds 1.75% and finishes H12020 up by around 2.00%. We repeat our message that, base case, EMU government bond crises will not erupt anymore. The Franco-German entente and support for the European Commission’s proposals (an increased multi-year EU budget and the joint funding structure of a EU recovery fund) have been decisive factors in counteracting the past 12 years’ rate divergence stress. Speculative market players have received a clear signal by the ECB and EMU’s political leadership that such games will be countered by flexible asset purchases on the one hand and fiscal solidarity on the other hand. We will observe a lot less rate divergence stress across EMU government bonds going forward, which will be reminiscent of the tapered-off FX speculation across EU national currencies over the second half of the nineties. EMU bond investors have to accept that capital growth will slow down and appreciate the positive roll-down return that is generated as a result of the still-attractive steepness across national government bond curves.
The end-of-week comments from sell-side credit market makers have triggered my attention. On the back of the strong momentum across risk assets, several IG or HY sectors and indicators are assessed against their tightest spread levels over a certain period. Traders still see value on an index level, as they exchange paper at 68% off the tights in IG hybrids versus Itraxx Main at 29%, Itraxx Crossover at 38%, BBB Senior at 44%, BB HY at 45%. A warning sign is in place here. Can we assume that corporate risk profiles remain stable after the coronavirus has impacted the global economy? If your answer is yes, maybe it serves to look at the tightest spread levels in the quest for returns. However, if not, a higher risk premium will remain in place as a reflection of higher balance sheet, rating, liquidity and default risk.
US Treasury rates went south. The US yield curve bull flattened on the back of equity market fatigue. US 30 year rates dropped 9bp to 1.37%. Since the start of the ALL-IN FED in early March, the average level of 30 year rates has stood at 1.38%. So, we have gone back to square one. Same goes for 10 year rates, which shed 5bp to 64bp. At the short end, 2 year rates were down by about 3bp this week, and finished at 16bp. The US rates volatility indicator or MOVE index (similar to the VIX index for equity markets) hovered around historic lows at 51bp. It reflects the enormous market steering power exerted by the US central bank. Implicit yield curve control has worked well for now. US TIPS (inflation-linked government bonds) have continued to outperform nominal treasuries. 10 year break-even rates were up 5bp, and closed at 1.33%. US 10 year real rates slipped to approximately -70bp! The aggressive convergence between 6 year German and 6 year US real rates was particularly interesting. The German April-2026 rate closed at -1.05% versus -0.85% on the July 2026 US TIPS security. This is a mere 20bp difference compared to 2019’s average of 1.65%! This is an important observation: it reveals one of the factors behind the stronger EUR-USD pair, or USD weakness of late. If one were to add the aggressive US money supply growth that might reach 25% in 2020, the odds for a stronger USD become even more challenging. Yet again, USD, JPY and CHF have maintained their flight to quality credentials. As such, finding the correct balance is the name of the game.
The European Government Bond (EGB) complex has been well bid last week. The high EUR 1.3 trillion intake by European banks (EUR 550 net add-on) of the ECB’s TLTRO III partially explains the strong EGB demand. New bank liquidity will be reinvested across European rates at the short end of yield curves. Most 10 years rates have dropped by 5bp to 7bp. Instead of watching rate convergence at the 10 year point, we get a whole new perspective when looking at the 5 year point. At this horizon, rate convergence has reached high levels. The 5 year German-Spanish spread sits at 55bp. Belgium and France’s 5 year funding costs require a small 18bp of extra spread to Germany. Italian BTP still demands 1.30% as a risk premium, but we expect it to reach the 1.00% over 2020. After 3 months of the PEPP program, the demand/supply technical will become a lot more positive going forward, as most debt agencies are ahead of the 2020 funding schedule.
Last week was rather uneventful for EUR IG. Lacklustre primary issuance alongside some risk-off headwinds pushed IG credit spreads back towards 1.50%. Total return eased a small 6bp, putting the YtD figure at -1.16%. The US central bank tiptoed into the US IG credit market. With a daily purchase amount between 350 million and 400 million, spreads have not tightened aggressively. Overall, IG quality credit is attractive for long term investors on both sides of the pond.
The EUR HY index has retreated by 43bp over the week to finish at -4.98% YtD. The Itraxx Crossover CDS index has widened by 20bp, closing at 4.08%. The sensitivity to equity sectors across EU and US HY markets has been high. The uncertainty on the default intensity over the next 12 month has been equally high. Primary issuance will slow down as we enter earnings season and July/August holidays. That leaves the sector exposed to increased liquidity risk as the quality in secondary market pricing by risk averse trading desks becomes dominant.
Emerging markets took a breather last week. Local Currency spreads (GBI-EM) tightened another 2bp to 3.96%. Hard Currency Investment Grade traded at 2.48% (-4bp). Broad Hard Currency (EMBIG) tightened 1bp to 4.93%. Sub-Sahara Africa spreads in Hard Currency tightened most and rallied 8bp to 7.32%.
Emerging market currencies remained unchanged last week. However, dispersion was high. The dollar index spot was slightly higher at 97.43. The most positive performers were the Uruguayan Peso (+1.2% in EUR terms), the South Korean Won (+0.4%) and the Indian Rupee (+0.4%). The Brazilian Real (-3.6% in EUR terms) continued its downward slide. Other weak performers were the Hungarian Forint (-2.7%) and the Mexican Peso (-2.2%).
Mexico and The Philippines cut rates by 50bp to 5.00% and 2.25% respectively. Hungary lowered its base rate by 15bp, reversing some of the monetary tightening from April. Turkey –surprisingly- held off on cutting rates amid a worsening inflation outlook.
The holiday season kicks off this week. On balance, fixed income investors have fared well over H1 2020 given the incurred systemic shock. The road to recovery is still long and uncertain.
Monetary and fiscal policy cooperation has the ability to backstop capital markets most of the time. But maybe not all the time. That requires high vigilance in portfolio construction, and pushes us to select sound balance sheets across governments and corporates.