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STATE OF AFFAIRS
The announcement of an effective corona vaccine candidate by Pfizer BioNTech impacted financial market valuations profoundly at the start of last week. However, by the end of the week bond markets had backpedalled most of the 10bp to 15bp surge in core developed market (DM) rates. Consensus among market commentators quickly centred around the idea that the prospect of a workable vaccine would catapult markets in pricing normalised conditions. That would confront us with persistent bear steepening pressure on German, US and other OECD yield curves. Yield curve steepening would unleash a proper rotation in equity markets in favour of the decade long underperforming value stocks at the expense of growth/quality equity. I will not tread onto the slippery path of equity market forecasting. As a bond investor, I do question the set of arguments used that would lead to an aggressive curve steepening at this juncture. I muse on this domain in the first paragraph. In the second paragraph I will even go a step further and reflect on how endogenous global financial markets have become. Valuations across financial assets change as a result of changes in underlying trend and bias of market participants. Asset inflation has been the clear trend since 2009. The prevailing bias that is often only changed as a result of a series of complex synchronised positioning changes by fellow market participants. The link with changes in fundamental macro and micro economic indicators has become extremely weak or even non-existent.
An important pre-condition for persistent curve steepening is a de-anchoring of central banks’ interest rate setting policy. That is currently not under discussion at all. Analysis of short-term rates inform us that the FED might start to tighten policy by 2024. Initial policy rate adjustment by the ECB are expected by 2026. Even if such timings would get pulled forward as a result of vaccine success, the increase of term premia will be limited. Current forward pricing is inspiring in that respect. US 10-year Treasury rates are priced at 1.43% 3 years forward and 1.56% 4 years forward. Given current US yield curve steepness, the market has priced today (with 10-year rates at 0.89%) a situation that pencils in 10-year rates around 1.50% over H1 2024. Fair. Market participants that believe that we will end below that level of 1.50% should not be afraid to run a healthy duration profile in US Treasuries today. Investors that believe we will arrive closer to 2.00% by then, for example in 10-year Treasuries, should markedly reduce interest rate sensitivity today. German 10-year rates 5 to 6 years forward sit at -0.12%. By the end of last week, 10-year German rates closed at -0.55%. Again, with markets pricing in a lift in deposit rates from -0.50% towards -0.40% by H1 2024, you need to ask yourself if 10-year bunds at -0.12% by then would fit your current investment stance? Here, the comparison with the Bank of Japan’s (BoJ) interest rate policy becomes interesting. Adopting a policy rate at a sticky -0.10% since memory 10-year Japanese government rates have been fluctuating in a tight range around 0.00%. The argument of explicit yield curve control of the 10-year rate point as sole explanatory factor is debatable as the BoJ has not been forced to use its full QE potential since long in order to control rates. One could imagine that the ECB might follow a similar path, and because of the permanent character of its asset purchase programs, market participants maintain a positive bias towards EMU rates and EMU duration risk. If the overriding bias would change, one has to become more prudent. Clear.
That brings me to the point that exogenous factors, such as vaccine discoveries in corona times, or promising macro-economic data points (even on the inflation front) will have less and less influence on the prevailing trends and bias of market participants. Since the Great Financial Crisis of 2008-2009, central bank QE programs have become increasingly mainstream. That has been reflected in a clear underlying bullish trend across public bond and equity markets. In bond markets the positive bias has been destabilised only once over the past 12 years. That was during the FED policy rate tightening cycle between end of 2015 and end of 2018. The FED also engaged in balance sheet tightening back then. However, QE tightening quickly led to financial market instability as markets found themselves into a tailspin sell-off over November, December 2018. Over 2019, the positive bond bias, also for equity markets, was fully restored. A new regime of close monetary and fiscal cooperation will strengthen the endogenous character of markets. The repair of inflation expectations in this respect might become a puzzling phenomenon, as this might express itself predominantly through lower real rates curves instead of higher nominal yield curves. Until the moment, of course, that genuine policy rate tightening becomes imminent. The bias might flip again and steer towards a defensive positioning, against expectations of rising long term interest rates.
By Wednesday last week, US 10-year Treasury rates were up by 16 basis points (bp) to close just below 1.00% at 0.98%. Pfizer’s 90% effective vaccine news ripped through US Treasury markets. Markets that, at the same time, had to absorb 3, 10 and 30 year new Treasury supply. Opportunity must have called as, by the end of the week, we closed the benchmark US 10-year rate at 0.895%. Guess ‘we won a battle but not the war’ sentiment prevailed. Still the upward adjustment of 8bp over the week was meaningful. The 30-year point attempted to break the 1.75% resistance but to no avail. We closed at 1.64%, up a mere 4bp versus Friday the 6th of November. I even believe market participants spoke more about the curve flattening than the steepening bout at the start of the week. The release of US CPI numbers were not alarming. Month-on-month figures were flat for headline and core readings. Year-over-year headline numbers came in at +1.2% with core CPI at +1.6%. These numbers will remain range-bound over the next 3 to 6 months.
Many eyes were focussed on the ECB Forum on Central Banking that is ordinarily held in Sintra, Portugal. This time it was an on-line gathering. The theme of the Forum was “Central banks in a shifting world”. The overall message was geared towards international cooperation among central banks to combat global economic, health and climate challenges. It stressed that a fluid, lengthy, interaction between monetary and fiscal policy makers is warranted, whilst controlling for financial stability. Lagarde made clear that a long duration of efforts is an essential factor in their policy mix. We genuinely need to get accustomed to the idea of omnipotent central banks. In the EMU rate space, the 10-year German bund tried to jump back into the old -30bp to -50bp range. Without success for the moment, as we settled at -55bp by Friday. Intra-EMU spread tightening was back in vogue. The JP Morgan EMU government bond index retreated by 29bp, but boasts a solid YtD result of +4.65%.
Higher and higher is the theme across European Investment Grade (IG) corporate bonds. The Iboxx index printed another all-time high, adding 24bp over the week. YtD total return sits at a comfortable +2.18%. The arguments calling for more of the same outweigh arguments that would call for prudence, given a wafer-thin buffer offered by the credit risk premium over a one, and certainly multiple year horizon.
For European High Yield (HY) it was another bumper week! I took the Tuesday session to take the sector into positive YtD territory. With a weekly performance of +1.07%, we settle for a positive +0.30% YtD reading. The synthetic Itraxx HY Crossover index closed at 3.00%. A target that many market participants had pencilled in for year-end. Again, we expect that the December 10th and 15th ECB and FED central bank meetings will keep markets in check. Gauging what happens under the surface will become important in order to assess 2021 potential. To be continued.
Once more, Emerging Market (EM) spreads saw significant tightening this week. Local currency spreads (GBI-EM), traded at 3.67% (-8bp). Hard currency Investment Grade is now at 2.06% (-8bp) and Broad Hard currency (EMBIG) at 4.12% (-13bp). Sub-Saharan Africa spreads in Hard currency tightened 15bp to trade at 6.42%.
EM currencies posted a positive weekly performance when measured in EUR (+0.55%). The JP Morgan Emerging Markets Currency index is flirting with the 56 level, a break of which would be very supportive going forward. Turkish Lira (+11.3% in EUR terms), Colombian Peso (+2.7%) and Thai Baht (+1.8%) are the winners; Peruvian Sol (-0.6% in EUR terms), Chilean Peso (-0.4%) and Indian Rupee (-0.3%) are the laggards. In September, after the first hike of the Turkish Central Bank, we wrote: “Most market participants read the hike as a possible return to independency of the CBRT but we believe this move is NOT a significant game changer, but rather a last convulsion of a central bank that has lost control a long time ago”. We repeat that when a President can determine the agenda of the Central Bank and change the Governor at his will, it’s not independent. It will not result in orthodox, credible policy making. Do you really think CBRT will raise rates by 4.00% or more next week?
In Peru, President Martin Vizcarra, who was the replacement of the impeached President Pedro Kuczynski, was impeached as well and replaced by Manuel Merino. So far, the impact on Peruvian Government Bonds has been limited, but the Peruvian Sol is now at its 15-year low (3.645) versus the USD.
The plans for a new (expensive) social program in Brazil are on hold, but it’s very likely that the current Bolsa Familia program will be extended. Whilst we believe that there is value in the Brazilian Real, we are less convinced on the bonds on supply concerns going forward.
Mexican inflation stands at 4.09%, above the central bank’s target zone, and recovering growth, resulted in a Banxico that kept its policy rate on hold at 4.25%. The high yield differential with peers in the region strengthens our case for holding MXN. In Chile, a second withdrawal of 10% of pension funds has been approved by the Chamber of Deputies. Argentina hopes to conclude another deal with the IMF on the extension of the USD 44 billion it already owes to the fund.
Hungary successfully launched a dual (10 and 30 year) tranche in EUR. Together with Poland, it threatens to veto EU recovery funds on the possible conditionality that make disbursements conditional to the rule of Law.
In South-Africa, the secretary of the ANC, Ace Magashule will have to appear for corruption charges. He is Ramaphosa’s main opponent within the ANC and a conviction would be a game changer for South Africa and the President’s anti-corruption program.
Despite the fact that EM sovereign supply is at record issuance of USD 200 billion YtD (and USD 689 billion total EM credit supply), EMD funds saw a very strong inflow this week, just above USD 2.5 billion, almost equally split between local and hard currency.
That economics is not a science like chemistry or physics, we can all agree on. It’s social at its core. It’s all about the behaviour of economic agents against an uncertain and unknown future. Financial markets are an ecosystem. I ponder that, most of the time, the ecosystem stands and survives on its own, has no affiliation with equilibrium models and is complex at its core. The fact that central banks have become a value setting force within, have strengthened the notion that the ecosystem has become highly endogenous and greatly detached from exogenous stress. Commodity markets and private marketplaces might become exceptions. Exceptions that more and more investors flee into.
I invite everyone to purchase and read the Alchemy of Finance authored by George Soros. He wrote the book back in 1987 and refreshed it in 1994. Reading it as a young market participant I did not fully grasp his concept of reflexivity. Now 30 years later I start to understand its true value and meaning. It was the inspiration for my musings this week. Keep safe.