Tail risks turn inwards.
A paradigm shift in the market


By Peter De Coensel,
CIO Fixed Income at DPAM


    • We expect financial markets to remain range-bound around current valuations over the next couple of weeks, or maybe even months. As countries have started to relax confinement conditions, market participants are looking for recovery signs in consumption and business activity. Our range-bound call rests on the following, experience-based expectations.


  • Firstly, given the V-shaped performance retracements since mid-March, speculative money and/or prudent institutional investors will become enticed to partially ‘lock-in’ acceptable year-to-date drawdowns. Investors with portfolios tilted towards US Treasuries and risk assets in the tech sector might even face positive results. This will support core bond markets and weaken spread products (Investment Grade [IG]& High Yield [HY]). Equity markets might lose their upward momentum and roll-over.

  • Secondly, whilst the tightening of strong-credit spreads reflects positively on the global policy response and is proof of relaxing financial conditions, we will run into more record–breaking, bad economic news flow going forward. This will put investor’s emotions to the test. If the recovery of economic activity is less impressive than hoped for, we will see additional downgrades of IG companies, or a higher number of defaulting/restructuring HY companies. The need for recapitalisation will rise. This explains the jump in convertible bond issuances, which we have witnessed over the past weeks. It is a fashionable instrument to fund companies on the cheap. The main cost is the measured equity dilution that is created by the offered equity optionality. Recapitalisations can be government led, privately sponsored or a combination of both. We will need to keep a close eye on the impact of government involvement in the capital structure. As soon as risk assets start to recycle above event risks, they might take a (prolonged) pause.

  • Thirdly, we estimate that the avalanche of new IG corporate bond issues will start to taper off. We have noticed a lot of frontloading in corporate funding programs. With less IG primary issuance, investors who are looking to source credit risk will turn to secondary markets. Unfortunately, liquidity conditions are still suboptimal here. Within the HY universe, we still need to see a genuine reopening of primary markets. New issuance might widen HY spreads, as has been the case in IG markets a month and a half ago.

    • Time has come to have a closer look at the EUR-USD currency pair. The US Dollar bull run against the Euro started back in the summer of 2008 at levels close to 1.60. Is this bull run about to turn? The short answer is ‘not yet’. Visibility is extremely low. This supports the USD next to the JPY, the CHF and gold as the portfolio construction channel adds these flight-to-safety exposures.


  • However we believe that a weak USD episode is in the making after the Covid-19 crisis. We reckon that investors will require a confirmation of global growth, most probably in the form of a coronavirus vaccine, in order to set USD debasement in motion. The trigger in this case would be sustained, high levels of USD money supply growth. Over the past two months, the FED has propelled M2 growth to roughly 20% year-over-year growth levels. That is 4 times greater than historical US nominal GDP growth. In normal times M2 grows is about 1 to 1.5 times the US nominal GDP growth (i.e. it grows by 5% to 7%). Essentially, the FED is reinjecting USD funding into the global trade system. That should bring on a reordering and build-up of working capital, and subsequently reflate economic activity. Again, this is a long-term process and takes time to filter through.

  • The EU and EMU lag the US in their efforts to push EUR money supply growth. We are confident that the ECB will respond firmly, and increase the PEPP (Pandemic Emergency Purchase Program) on June 4. In addition they will support funding of the European Recovery fund over the second half of 2020 and beyond. In conjunction with the very accommodative, long-term funding programs (TLTRO III), there is room for EUR debasement over the next 6 to 12 months. We do not rule out a retest of the 2017 March lows (at 1.0340).

  • In sum, look for consensus on global growth acceleration to initiate a bearish USD view. We are still far from reaching such a consensus. As such, you should not rely only on traditional interest rate differentials, or purely count on ‘monetarist-like’ trends in money supply growth ratios. Instead, monitor the global USD-funding conditions, and the synchronized acceleration of global trade volumes.

    • The German Constitutional Court now requires the ECB to provide a detailed explanation on the real economic benefits of its quantitative easing (QE) asset purchase program. The ECB will comply with this request and get back to business. According to us, this event belongs in the column called ’Noise’.


    • Last week, we wrote ‘Expect more steepening pressure at the longer end of the US yield curve.’ The May/June/July US Treasury funding schedule, which was released last week, confirmed our predictions. The supersized (i.e. close to USD 3 trillion) refunding programme will increase the sizes of 10- and 30 year auctions. An inaugural 20 year Treasury issue will be added to the yield curve on May 20 for an amount of USD 20 billion. Humour does exist at the department of the US Treasury. Due to a continued risk-averse sentiment, demand for short-term paper will be high. This has pushed 2 year US notes to a historic low of 13 basis points (bp). Two year notes closed at 16bp by week’s end. The 30 year Treasury bond went from 1.25% to 1.40%, as the market tried to digest the upcoming supply. The 30 year bond closed at 1.38% after non-farm payroll figures. April payrolls plummeted 20.5 million, erasing 23 million jobs created since 2010. Around 18 million of these should be considered temporary layoffs. Returning to the US yield curve, 10 year notes closed at 0.68%. Medium term we expect 10 year US rates to fluctuate between their March-9 lows of 0.31% and 1.00%. That puts us in mid-range today. We have achieved this 1.00% upper bound in 10 year notes on the back of our conviction that the maximum steepness of the US yield curve sits at around 150bp to 175bp, expressed through the 2 year to 30 year rate differential. We have observed 2y30y yield curve steepness up to 350bp at the end of 1992 and 2003’s third-quarter rate-cutting cycles. It reached 390bp during the second quarter of 2011, as the FED’s QE programs pushed investors up the risk curve and away from safe long bonds. However, since QE was firmly adopted by other major central banks we have never revisited such levels. The presence of continued developed- and emerging market (EM) central bank QE might see US 30 year rates reach a peak of around 1.75%, with 2 year rates at 0.25% (or lower)as anchored by the Fed’s zero-interest-rate policy. Note: the second quarter Treasury funding schedule has no US TIPS auctions planned; a decision that should support inflation expectations.

    • German 10 year rates climbed 5bp and closed at -54bp. Clearly the -50bp deposit rate has exerted its gravity on 10 year Bunds. The amount of criticism from academics and market participant alike on the ECB’s negative interest rate policy continues to grow. The unintended negative consequences are outpacing long-term benefits. These consequences will likely push the ECB to normalise its deposit rate to zero in a distant future. It also skews our expected range of 10 year bunds to anywhere between -65bp and 5bp over the next 24 months. At -54bp we are closer to a ‘top valuation’. This aligns with our longer-run base case of intra-EMU rate convergence in government bonds. The decision of the German Constitutional Court put this base case to the test once more. We mostly consider last week to be an annoying hiccup. We expect that EMU government bond markets are preparing for a sizeable increase of the current EUR 750 billion emergency QE program. All options are open. On June 4, the ECB might even decide to double up and opt for a EUR 1,500 billion purchase program into 2021. That should further dampen volatility. Low volatility is a fertile backdrop for rate convergence of semi-core government bonds, next to more meaningful credit spread tightening for Southern European member countries.

    • EUR IG corporate bonds ended their six-week bull run. The sector recovered 4.11% between March 23 and May 1. Last week, core yield curves bear steepened causing EUR IG to give back 41 bp in performance. Spreads consolidated at 1.95%, still offering a yield of 1.30%. EUR IG remains in very high demand. The best-in-class names in particular brought about the highest bid-to-cover ratios, as new issuance hit the market. We understand that investors prefer the higher stability of ultra-high quality credit compared to an, at times, erratic EMU government bond sector. Thanks to the FED’s credit easing measures, we do not hesitate to allocate our funds to quality USD IG corporates. Spreads have also consolidated at 2.07%, with an attractive yield of 2.8%.

    • Last week, EUR HY corporate bonds performance backtracked 71bp. The ECB is studying the impact of broadening the scope of its Credit Sector Purchase Program to include HY credit. They might adopt a similar approach to the FED’s program, buying EUR denominated paper of falling angels. Pinning a look back date will decide on who is in and who is out of scope. Spreads on EUR HY have closed at around 6.5%, and offered a 5.9% yield. Market dispersion has been on the rise within the EUR HY universe. We have observed the opposite phenomenon in the US HY universe, as the energy sector recovered well on the back of rising spot oil prices.

    • Emerging bond markets started the first week of May on a good foot. Local currency spreads (GBI-EM) tightened 20bp towards 410bp, and were back to early 2020 levels. In hard currency, spreads were tighter as well. Hard currency IG traded at 330bp (-15bp). Broad hard currency (EMBIG) eased 40bp (to 600bp) and Sub-Saharan Africa spreads in hard currency shrunk by 50bp (to 885bp).


  • Emerging market currencies had a very good week. Nigerian Naira (+6.0% in EUR terms), Mexican Peso (+5.2%), South African Rand (+3.9%), Russian Rouble (+2.7%), Colombian Peso (+2.6%) were last week’s best performing currencies. Uruguayan Peso (-1.0% in EUR terms), Brazilian Real (-3.1%) and Dominican Republic Peso (-3.6%) were among the few currencies that saw negative returns versus the EUR.

  • If we combine rates and FX returns, Colombia has been last week’s strongest performer (+6.6%), followed by Mexico (+6.5%) and South Africa (+6.4%). Turkey (-2.9%), Brazil (-1.5%) and China (-0.4%) were the weakest performers.

    • We believe local rates will continue to perform strongly in the weeks ahead. Helped by low inflation, EM central banks will continue to cut rates. Attractive real yields (compared to US Treasuries) will be supportive for the asset class.


    • This week’s fixed income update features only one message: tail risks turn inwards, closing in towards the mean of expected outcomes within financial markets.


  • We define tail risks as the impact of health, climate and political disruptions on volatility profiles across sectors, from core bonds to equity. Essentially, it comes down to a paradigm shift in the market. This market paradigm is characterised by an increasing number of high-volatility episodes that impact global financial market valuations.

  • We want to stress that the direct effect of such a shift is an increase in risk aversion. It will keep specific sectors at high valuations for longer. The stickiness of negative yielding 10 or 30 year German bunds serves as a good example. We can also look at the drop in expected returns of 10 year Treasuries, (currently just below 70bp). It might inch towards (and beyond) the historic lows of early March. In the meantime market participants still fight such high valuations.

    • As soon as investment behaviour accepts this new paradigm, every high quality security, from government bonds to equity, will outperform securities that are ill-equipped to handle high levels of uncertainty. Central bank purchase programs will become the new standard, and essentially serve as shock absorbers in order to keep financial markets and capitalism afloat.


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