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STATE OF AFFAIRS
The rally in 10-year German bunds was the eye-catching market event of the week. A downward adjustment of almost 10 basis points (bp) towards -0.63% moves the needle further away from the -30bp to -50bp range we got accustomed to in 10-year Bunds. Clearly, next to a quest for yield, there is also a chase for true risk-free government bonds. The Year-to-Date total return for an investor exclusively holding German government bonds stands at +3.53%. It’s obvious for active bond managers, but the fact the German yield curve is in negative territory might discourage certain investors from positioning in this market. We touched upon the scarcity element last week and warned for even less free float over 2021. Another factor that is pushing German rates deeper into negative territory is the presence of a deep and liquid German interest rate futures market. This liquid futures market is used by a broad spectrum of investors or pure speculators with varying investment horizons. This also leads to an increasing importance of market technicals versus the longer-term impact of cyclical economic indicators. This leads to the phenomenon that markets can deviate for much longer than some participants are able to hold their breath and position for an expected, common sense, normalisation of rates towards less negative levels. The monetary policy set-up, however, is calling for more accommodative actions, not fewer. That should not per definition lead to 10-year German bunds aiming for -0.75%, or revisiting mid-March lows at -0.90%. The ECB would hope, of course, that it would push portfolio repositioning less in favour of Bunds but more in favour of higher yielding sectors across bond sectors. Now, here is the point where the current ECB policy might run into trouble. Investors are very focused on correct compensation levels or credit risk premia. At this juncture, we might enter in an area where investors lack confidence to chase, for example, 10-year Spain or Portugal into negative territory. Both markets closed 10-year rates around +0.15%. Such an attitude could set-up core rates for another downward push. Investors and/or speculators could accelerate the closing of short positions. Fact is that probabilities for an ECB policy rate change are on the rise. The goalposts might change again. Add to that early November US elections translating into potential for disruptive market conditions. Both conditions might push weak hands into cutting their short bund positions. Indeed, it has been a long and difficult year, and many participants require more visibility before tackling another challenging 2021.
US Consumer Price Index numbers rose towards 1.6% Year-over-Year. Core US inflation printed at 1.7% for a second month. The deflationary shock that occurred over Q2 2020 pushed headline inflation close to 0.00%. However core inflation never dipped below 1.00%. Our confidence that the FED will succeed in attaining 2%+ inflation levels is on the rise. Our preferred 5Y5Y forward inflation swap indicator ended the week at 2.15%. The US investor base is not fighting the tendency for lower real rates. Of interest was the fact that the S&P Goldman Sachs Commodity index showed renewed strength. Bloomberg defines the S&P GSCI® as “a widely recognized […] leading measure of general price movements and inflation in the world economy. It provides investors with a reliable and publicly available benchmark for investment performance in the commodity markets”. Supply channels will go through a renewed test, as this second COVID-19 pandemic wave might overtake the March/April wave. Capacity gets deeply scarred. Any broad-based return of demand over 2021 will raise inflationary pressures. It becomes visible across specific commodity products. Wheat was a case in point over the past week. It surged towards a new five year high. We repeat that higher inflation expectations will be translated through lower real yields, as long as the central banks call for high flexibility in their asset purchase programs. Such conditions were present in the early 50s and over the 70s. Investor still fear inflation-linked bonds, given their poor performance during market stress. However investors should focus on the resolve shown by central banks and not on illiquidity hiccups that occur once in a while. Next stop in the US inflation debate is October 30, with the release of the core Personal Consumption Expenditures price index inflation figures. The latest print got us 1.6%.
As the Treasury market prepares for new 20-year supply next week, we have noticed steady conditions at the 2-year to 5-year part of the curve, and some flight to safety in the longer end. US 10-rates dropped 3bp towards 0.745%, versus 4bp on the 30-year point closing at 1.53%. A tug of war is playing out between real and nominal US rates. The negative correlation between real rates and inflation expectations remains prevalent. By comparing this key US interest with the German comparator, one obtains a simple, but often-used valuation indicator on the US 10-year point. It is known as ‘the Atlantic spread’. This indicator closed at 136bp. The 25-year average sits at 64bp. Interestingly the Atlantic spread has been in an ascending channel since 1995, thanks to a gentle downward slide of the 10-year German bund rate. It begs the question whether this spread should ultimately retest its long-term average around 65bp. If 10-year bunds find it hard to normalise to the upside, can we expect 10-year US rates to test the zero-lower bound over the next couple of years? Don’t rule this out. In fact, in rates, the range of possible outcomes is rising, not falling.
Within EMU government bonds it was difficult to keep pace with the German bund rally. Indeed, Italian, Spanish and Portuguese 10 year rates fell ‘only’ around 7 to 8bp. As stated, we observed solid support for the most expensively-valued Eurozone government bonds. As EMU government bond supply is dropping fast over November and December, we might see the start of a consolidation in intra EMU rate convergence. We expect, at the margin, less support for continued rate convergence over the last stretch of 2020.
European investment grade (IG) corporate profited from the steep drop in rates and realized an all-time high print on Friday! The Iboxx corporate index started its career at 100 on January 1, 1999. On Friday, we closed at 241.58, a new historic high, representing a 4.13% annualised return since its inception. Performance at the long end was astonishing. As has been the case for the US IG corporate bond market, expect the effective duration of the index, currently around 5.3 years to accelerate higher as more and more companies start tapping the 20-year to 30-year part of the curve. The US IG corporate index has an effective duration of 8.37 years. The target is set for Europe over the next decade. The institutional investment community is craving for long end supply. This will be met with a positive response, as large corporates will lock in historically cheap funding levels.
The European high yield (HY) sector took a pause. Tensions are rising in the background across risk assets. Equity volatility remains stubbornly high. The sector gets paralysed by COVID-19 infection acceleration. We smell the perfume of risk aversion. Unlike European IG corporate bond, the European HY index is still three percentage points away from reaching a new high. Eventually, the sector will succeed…with a yield around 3.9%, this might occur by the end of 2021. A workable vaccine getting administered in size over 2021 is a necessary condition.
Emerging market (EM) spreads moved sideways last week. Local Currency spreads (GBI-EM), traded unchanged at 3.82%. Hard Currency IG traded at 2.11% (-8bp). Broad Hard Currency (EMBIG) tightened 2bp to 4.36%. Sub-Saharan Africa spreads in Hard Currency widened 14bp to 7.18%.
EM currencies posted a positive weekly performance. Some exotic names out of our investible universe are leading the pack: Pakistan Rupee (+1.8% in EUR terms), Honduras Lempira (+1.7%) and Mongolian Tugrik (+1.5%). At the bottom, the CE3 currencies: Hungarian Forint (-2.4% in EUR terms), Polish Zloty (-2.1%) and Czech Koruna (-1.2%), punished for their inflation figures outside of the central bank target zone. The offshore Yuan (excluded from our universe) dropped versus the Dollar after the People’s Bank of China announced financial institutions no longer need to set aside cash when purchasing foreign exchange for clients through currency forwards. The Yuan traded briefly above 6.76 but quickly reversed the losses, trading below 6.70 at the end of the week.
The Annual Meetings of the IMF and World Bank were held virtually due to the pandemic. In its latest outlook, the IMF did revise the growth expectations upward for Ems to -3.3% in 2020 (from -3.0 in June projections) and to +6.0% in 2021 (from 5.9%). The swift recovery in China has surprised to the upside and Asia is expected to lead the pack in terms of growth rates, while Latin America and Middle East should be the laggards. At the same time, the G20 announced its decision to extend Debt Service Suspension Initiation (DSSI) for Lower Income Countries by six months. The statement did not make this DSSI extension conditional on private sector participation, which reduces risks for bondholders. Although DSSIs help relieve liquidity pressures in the short term, they do not solve potential solvency pressures in the medium term. Strong growth will be required to ease restructuring risks
In South-Africa, the crucial budget statement has been postponed from October 21 to 28. Meanwhile, President Ramaphosa unveiled its Economic Recovery and Reconstruction Plan. The plan targets 3% GDP growth, with a focus on job creation via infrastructure investment (>ZAR 1 billion over four years) and mass employment programmes (800,000 work opportunities in public works). It also aims to address energy shortages within two years, expanding broadband access, reversing the decline of manufacturing and resuscitating the tourism sector. While all those would help unleash the growth potential in South-Africa and improve revenues in the budget, it seems that investors are also waiting for a strong commitment to curb spending, in order to be reassured debt levels can ease back to a sustainable path.
Core nominal rates are under the implicit or explicit control of central banks. In the space of core long term rates, it pays off not to exclude the unexpected.
Global business condition indicators, especially as gauging the potential once the pandemic fades, tell us to prepare for higher rates. Central bank policy tells us that purchase programs will be the norm over the next couple of years in order to support fiscal policy initiatives. Monetary policy rates will remain at the effective lower bound, with the potential to shift lower, over the next three to five years. The business cycle market indicators are clashing with central bank all-in policies. The trend for lower real rates is currently strong.
If anything, expect and prepare for higher volatility levels in nominal rates over 2021 and beyond.