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STATE OF AFFAIRS
Anxiety is on the rise in global bond markets. Over the past week, 10-year government rates in developed markets fell victim to a strengthening reflation narrative that, according to market strategists, could push long-term rates over the edge into a prolonged bear market. In the following paragraphs, I want to describe a scenario for short and long-term rates that marries reflationary conditions over the next couple of years with the influence exerted on the yield curve from public authorities (monetary & fiscal) working together whilst trying to tackle societal challenges and imbalances.
The monetary and fiscal policy response initiated over March 2020, as a reaction to the pandemic’s aggressive deflationary shock on societies, succeeded in limiting the blow to output. 2020 GDP figures show that, in the end, the world escaped the worst or base-case predictions and are settling for the more optimistic scenarios that were released over the summer of 2020. These better GDP prints hit the screens the very moment that January year-over-year inflation readings surprised on the upside. Indeed, we can expect the inflation prints over 2021 will easily overshoot central banks’ medium-term targets. Investors should brace for a lift in US Consumer Price Index or Personal Consumption Expenditures inflation indicators that put them in a 3.00% to 2.50% range over this year. In the EU, expect a similar picture, pushing EU Harmonised Index of Consumer Prices inflation readings towards the appropriate ECB 1.75%-2.00% target range. Base effects, temporary factors (undoing VAT reductions) or the impact of volatile food and energy components will reinforce this process. US bond markets have advanced most in pricing the above scenario, as the break-even rates curve has fully inverted. Two year market-based inflation expectations expressed as the gap between real and nominal rates sits at 2.50% on average over each of the next two years. At the 30-year point we table in 2.15%, fully in-line with the FED’s inflation mandate. Effectively, the market expects inflation pressure to be skewed over the next two to three years, followed thereafter by a prolonged episode that coincides with the flexible target adopted by the FED (i.e. inflation around the 2.00% level). This explains the contentment expressed of late by several FED governors, telling the public that the FED policy is generating the desired outcomes. In the Eurozone, a similar process is unfolding with a lag. 10-year German inflation expectations rose from around 0.50% in the spring of last year, towards 1.10% today. Since the start of the ECB’s quantitative easing (QE) back in 2015, we observe a high print of 1.40% on this metric. Only between 2009 and 2013 did 10-year German inflation expectations fluctuate between 1.50% and 2.00%, or more or less in line with ECB inflation aspirations. We can expect that the inversion of the European break-even rate curve will ensue as inflation prints will get a boost over the remainder of 2021. Moreover, the advent of higher inflation volatility(literally rising as a Phoenix from the ashes of inflation disappointment over the past decade) will increase investor interest towards real rates exposure. This will buttress inflation expectations over the short-term. Key question remains: in what direction will long-term nominal and real rates evolve?
An answer to the above question requires us to look at three aspects. First we need to reflect on the path and destination of main central bank policy rates i.e. what is the terminal policy rate? Second, how will central banks deploy their respective policy instruments? Third, what are the overall societal objectives that policy makers want to strive for in order to restore some balance to the local and international order?
If we take the Eurozone and US overnight indexed swap (OIS) rates and calculate-build the expectations of such reference rate over the next 5 years, we observe that, in the Eurozone, we arrive at -0.41% versus +0.41% in the US. Thus, markets expect that, somewhere along the next 5 years, we might see one rate hike in the Eurozone as well as in the US. Looking beyond at the 10-year point, or early in the next decade, we arrive at a so-called potential terminal ECB policy rate that sits at +0.25%. For the US we pencil in FED fund terminal policy rate around +1.50%. One can, quite easily in fact, accept such levels on the back of the unseen rise in indebtedness witnessed over the past year. On average, over 2020 alone, government debt as a % of GDP rose by 20 percentage points within the OECD. Indeed, the US Congressional Budget Office (CBO) expects that the US federal debt levels might rise toward 109% on average over this decade, to 142% over the next decade and 195% debt to GDP between 2041 and 2050. One could state that, over the next 30 years, the US federal indebtedness will have morphed into Japans’ reality of today. For the Eurozone we pencil in a shorter timeframe. As debt levels grow, expect the productivity of each additional EUR or USD of debt to decrease as well. Any counterargument will have to come from an increase in total factor productivity or advances in technology that can be translated into higher human productivity.
The above path of indebtedness brings us to the fate of nominal and real long term rates. The current intensity of central bank asset purchase programs (i.e. QE) buffers any aggressive rise in long term rates. However, in the US, the 30-year rate is close to breaking the 2.00% threshold. One can expect that the FED will maintain its QE intervention in order to contain any undue tightening of financial conditions. Expect the FED to become more vocal on introducing another maturity extension program, limiting the pressure on long-term interest rates. The last policy option would take the shape of explicit yield curve control. This was the case between 1942 and 1951. Short-term rates were cemented at 0.375% whereas government bond rates between 10 and 30 years where capped at 2.5%. Given today’s structural economic imbalances, the Powell-Yellen tandem will intervene the moment 10-year Treasury rates rise towards 1.5% or 30-year rates towards 2.5%. While the background is completely different from 75 years ago, the flavour of the magic potion might be similar. Issues with monetary policy credibility and exit path or exit risk are at the core of explicit yield curve considerations. The FED balance sheet as a percentage of GDP sits at 32%. In the Eurozone, we arrive at 60% for a 132% figure in Japan. Two messages: there is plenty of room for the FED and ECB to grow their balance sheet and for US 30-year rates to reach attractive buy levels. Anecdotally, today one can invest in the highest quality investment grade US corporate bonds from Microsoft or Apple, locking in yields between 2.60% and 2.80% respectively. For Eurozone government bonds, the outlook for long rates is more challenging given the disparity among national government bond markets. On the subject of long-term real rates we expect that these will behave fairly stable relative to nominal rates as long as policy rates remain at the zero or negative lower bound. Also, expect QE purchase programs to inflict an outsized impact on the level of real rates across US TIPS or EU linkers. The impact has been stellar since April 2020. As a thought experiment, how would long-term nominal and real rates react the moment the ECB lowers policy rates ? My mind goes for a drop deeper into negative territory by real rates alongside stable to slightly higher nominal long term rates. That would suit the ECB just fine.
The third factor that requires long rates to remain lower for longer is vested in the challenges posed by climate change, energy consumption patterns, education levels, quality of infrastructure and income distribution. Once again Japan can be our guide. The Japanese economy and society is achieving good scores on each of the above. The incurred opportunity cost becomes visible through a ‘dead’ government bond market. Nominal and real rate volatility have cratered. Inflation expectations have gone out of the window as well. 10-year real and nominal rates have been rotating around the 0.00% point. What is the probability of such an outcome for the Eurozone government bond market? It is probably higher than it is for the US Treasury market. But then again.
The US yield curve added another episode of bear steepening. 2-year Treasuries dropped 1 basis point (bp) to 0.10% against a rise of 10bp for 10-year rates finishing at 1.165%. The 30-year tenor climbed a hefty 14bp closing at 1.97%. US TIPS were a lot more resilient. 2-year real rates dropped 5bp to -2.10%. 10-year real rates were unchanged over the week at -1.03%. 30-year real rates rose by 8bp to -0.21%. Most of the action occurs on the nominal curve. The unemployment data from last Friday reveal deep scarring. As US Treasury valuations increase in attractiveness a smile returns on the face of global bond investors. Fixed income opportunity is on the rise.
The sell-off in US rates flipped 10-year German bund rates into its more comfortable -0.30% to -0.50% range finishing at -0.45%. Italian political uncertainty faded as expectations for a Draghi I government became consensus. The high probability attached to such an optimal outcome shaved 11bp from 10-year BTP’s closing at 0.53%, near the historical low put in place mid-December last year at 0.52%. The former ECB president doesn’t even have to speak in ‘whatever it takes’ rhetoric to push the 10-year Bund-BTP spread below 100bp! Our call for further intra-EMU rate convergence stands firm. European Government Bonds lost 25bp in performance and unnerved investors with a year-to-date (YtD) result of -0.94%.
We will have a closer look at European and US credit over the next couple of weeks. Resilience is unquestioned. The European Iboxx corporate bond universe added 3bp in performance and limited the YtD damage to -0.33%. The European ICE Bank of America High Yield index steamed ahead with a week result of +0.83% and a promising start to 2021 showing a +1.24% in performance tables.
A higher pace of vaccine rollouts and President Biden’s push for a USD 1.9 trillion fiscal stimulus lifted emerging market (EM) stocks and spreads of hard currency bonds, while the dollar slightly weighed on EM local currencies.
Returns in EUR were however strongly positive for local currency debt investors with the index from JP Morgan (GBI-EM GD) returning 1.35% over the week. YtD, the index is up 0.98%. In terms of spreads, local debt tightened by 4bp towards 355bp, whereas hard currency debt (JPM EMBI GD) tightened by 7bp. The HY component of the index clearly outperformed (-18bp). Regionally, Africa scored best, tightening 14bp, despite the noise created by Ethiopia’s restructuring announcement at the end of last week.
Flows into EM debt remained strong at USD 3.7 billion. Flows into hard currency outpaced flows into local currency funds. At the same time, supply was muted after a record January, with no deals from sovereign issuers and a few quasi-sovereigns from Indonesia and Mexico coming to the primary market.
Busy week in India, where a set of budget figures gave a nasty surprise. Expectations of higher fiscal deficits – from 9.5% in FY 2021 to 4.5% by FY 2026 – will result in additional borrowings over Q1 2021 of about INR 800 billion. As a result yields widened by more than 20bp. A potential index inclusion could help absorb some of the issuance in the future, but domestic sources will need to be involved at some point. Friday’s RBI meeting disappointed on this front, providing no new incentives for banks to buy government bonds and not releasing information about its own bond purchases.
The Czech National Bank kept borrowing costs unchanged at 0.25% and left the outlook for gradual interest rate normalisation intact. Central bank Governor Jiri Rusnok alluded to two policy rate hikes over 2021.
As equity investors always look through the current problems and lofty valuations putting their hope on the long-term return superiority of the asset class, I invite bond investors to look through the current inflation mania as well. If anything, somewhat higher bond yields will, by definition and without hope, lift future return expectations.
The complex cocktail of short-term reflationary conditions that will show as we make our way out of this pandemic will meet an even more complex set of conditions that relate to an attenuation of imbalances. The cost and quality of education, the lack of proper income distribution, the cost of climate change alongside the required transformation of infrastructure and human behaviour are factors that require attention and funding.
In order to have a slim chance of success in the partial realisation of the above goals, the cost of funding cannot spiral out of control. On the contrary, sustained and active government and central bank intervention will be required. Central bank intervention might cool down of its own the moment the hard reality and weight of our aggregate debt burden reveal themselves through lower potential growth rates. Japan as a blueprint for what’s to come cannot be ruled out.