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STATE OF AFFAIRS
May features many short weeks as public holidays are scattered over the month. US Memorial Day on Monday May 25 will indirectly “suspend” the normal functioning of global financial markets for a day. Effectively, and this has to be repeated, over the past two and a half months, global rate, credit, currency and equity markets have taken their cue from US markets. We continue to look to the US for guidance on valuations within the EU and across the rest of the world.
First, no doubt, the US Fed’s shock and awe quantitative easing (QE) tactics still ripple through week after week. The Fed minutes released last Wednesday shed some light on future policy. Currently, the Fed’s Treasury purchases amount to USD 5 billion per day or USD 25 billion per week. This emergency regime, including the flexibility to increase intervention, will continue over the summer due to the lack of visibility on the economic recovery. The minutes seem to imply that the Fed wants to adopt an outcome-based type of guidance while maintaining steady QE asset purchases. The zero interest rate policy will be kept in place as long as unemployment has not recovered towards 4% or 3.5%. According to consensus, reaching such an objective, from a possible 20% high in unemployment over the next few months, will take 4 to 5 years. QE will have to remain in place in order to finance persistently high budget deficits over a similar period. Thanks to QE, stabilizing the short and intermediate parts of the yield curve will not be an issue. Thus, only the 10-year+ part of the yield curve could see upward rate pressure. However, as monetary and fiscal policies are currently developed and implemented cooperatively by the relevant authorities, we expect the Fed to contain excessive steepening pressure and increase intervention if required. Rising borrowing costs at the 30-year point would hurt households most, with businesses and governments sharing second place. Such a scenario will be avoided at all costs by monetary/fiscal policymaking bodies. This leaves us with inflation as the unreliable parameter. Again, consensus has it that we are walking a path of disinflation. Time will tell, but we opt for prudence as the historical odds against such a view are high, with little upward surprises priced in current inflation expectations. This risk angle dominates when tilting in favour of inflation-linked bonds. The optionality angle comes second, but makes for attractive pay-outs the moment the unexpected materializes.
European Purchasing Managers’ Indices (PMI) bounced back without conviction. They remain in deep contraction territory, meaning that May is effectively as bad as April. Services rebounded more than manufacturing, but a look at other data series out last week is still a shocking exercise. April EU27 new car registrations were down 76.3%; the German ZEW Survey Current Situation Index was down -93.5 in May from -86.6 in April, though the Survey Expectations Index rose to 51 from 30, reflecting some optimism; the Dutch Consumer Confidence Index cratered to -31, near the lows of 2009 and early 2013 …
Is the recovery across risk assets in financial markets since March 18 in sync with the dreadful trends observed in the real economy? We are aware that markets are anticipatory in nature and act like a discounting machine. But one also has to take into account the harm inflicted across sectors, the “expected and not expected” increase in corporate defaults, the uncertain outlook in consumption patterns and social behaviour, the length of the precautionary “saving for a rainy day” reflex… the list is long, yet the outlook expressed by markets is highly optimistic. How long can the disconnect be maintained?
The inaugural 20-year US Treasury auction was very successful on May 20. The new bond was auctioned at a yield of 1.22% and closed the week at 1.12%. Strikingly,10-year and 30-year rates backed up marginally by 1.5 basis point (bp) and 3 bp to close at 0.66% and 1.37% respectively. There was some nervousness about potential negative interest rate policies, but we remain firm on that matter and attach almost 0% probability that the Fed will pull its Funds Rate below 0%.
German 10-year rates inched up to -49 bp. Year-to-date, on average, 10-year bunds have traded at -44 bp. Clearly, the action was found in promising EMU government bond rate convergence. The catalyst was the Merkel-Macron breakthrough agreement-in-principle on the European Recovery Fund structure. The Fund might be an initial step to allow an EU institution like the European Commission to issue bonds backed by increased EU budget contributions. This would be evidence of solidarity, since funds would be redistributed as grants to the EU regions most heavily impacted by Covid-19. Details should be finalized at the June 18-19 EU summit. Already Holland, Austria, Denmark and Sweden have voiced their discontent. Then again, markets did not wait and kick-started a rate convergence move following this historic event. What the ECB could not accomplish on its own was achieved through common sense EU politics. Spanish 10-year rates dropped 13 bp to 0.62%, closely followed by Portuguese 10-year rates finishing 15 bp lower at 0.72%. Italian government bonds (BTPs) profited most. Ten-year Italian rates dropped 27 bp to 1.59%. The closely monitored bund-BTP spread closed at 218 bp. The Recovery Fund negotiations will only be labelled a success if the EU can tap the structure in the future. A positive long-term outcome might see a tightening of spreads to bunds of 10 bp to 50 bp over the summer for, respectively, European semi-core and periphery government bonds. However, if the Recovery Fund’s only use is to cushion the impact of the Covid-19 crisis, markets might quickly do an about-face regarding rate convergence. A new EU debt crisis might lurk around the corner. Yes, there’s a fine line between love and hate in the European government bond universe.
EUR investment grade (IG) corporate bonds recovered nicely. Over the past week, the EUR Iboxx corporate bond index gained 45 bp. Year-to-date, the decline narrowed to 3.25%. EUR IG corporates might draw increasing interest again on the back of “recovering” EMU government bonds. Primary issuance in EUR and USD IG corporates will hit record levels over 2020. This attracts demand. With developed market central banks expected to keep policy rates at 0% for years to come, the appeal of IG corporates should remain steady.
EUR high yield (HY) bonds posted their third best weekly performance since the March crash, adding 1.79%. As a result, their year-to-date decline was reduced to 8.98%. We do expect more companies to drop out of the IG universe to enter the HY universe. This will keep an IG/HY spread decompression in place over the remainder of 2020. On balance, we expect HY performance to be less resilient than IG performance.
Emerging market debt had another positive week, with local currency spreads (GBI-EM) tightening another 10 bp to 400 bp. In hard currency, spreads tightened even more. Hard currency IG debt traded at 300 bp (-30 bp). Broad hard currency (EMBIG) tightened by 50 bp to 550 bp and Sub-Saharan Africa spreads in hard currency tightened by 80 bp to 805 bp.
Emerging market currencies had a very good week as well. Currencies that performed best were those that had recorded the weakest year-to-date performances so far. However, Asian currencies, which had performed relatively well year-to-date, underperformed last week. This is a good indicator of improving sentiment in emerging markets. The Brazilian Real (+6.0% in EUR terms), South African Rand (+4.7%), Mexican Peso (+4.6%) and Colombian Peso (+2.8%) were the best performing currencies last week. The Argentine Peso (-1.4% in EUR terms), Indian Rupee (-1.3%), Chinese Renminbi (-1.2%) and South Korean Won (-1.2%) were amongst the currencies that posted negative returns versus the EUR.
We believe that emerging markets will continue to do well in the coming weeks. We are keeping a close eye on China-US relations as they are a potential source of market stress. Also, Brazil’s President is coming under more pressure after the Supreme Court released a video of him threatening to remove Rio’s police chief. Meanwhile, the Argentine government announced last Thursday evening that it would delay its debt swap offer till June 2. In practice, this means that the government will fail to make a USD 503 million debt payment, thereby placing the South American country’s entire foreign debt in default.
The main conclusion of today centres on the impact of central banks’ zero or negative interest rate policies on the future valuations of longer-term government rates and corporate funding levels. We see no evidence that might push central banks away from the effective zero lower bound over the next 4 years. This opens the door to attractive carry and roll-down returns over that period across fixed income solutions.
In addition, the seasoned bond manager will seek to capitalize on attractive bond convexity at the very long end of government or corporate credit curves. As a result of the volatility spike in rates during March, appealing curvature has appeared for select government and corporate yield curves. Extracting positive convexity value can make a difference. If applied selectively and with caution, such a strategy can enhance bond returns over the next cycle.