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STATE OF AFFAIRS
Often central bank press conferences confirm consensus expectations with potentially some minor twists that stir the market debate for a couple of days. Last week’s US FED meeting and ensuing press conference does not qualify under this banner. Such a bold statement resides on the back of some extraordinary changes that occurred across the US yield curve, the broad-based USD and the sudden spike in intermediate US real rates. I will comment on each of those first-order market reactions. However, I will try to go beyond specific market moves and look at potential broader implications of a more sensitive US central bank. Has the FED taken away the punchbowl early, thus shortening the business cycle? Have US bond markets smelled trouble ahead and prepared for inflation disappointments over 2023 and beyond? Has anyone considered the probability that markets at large are confronted with an economic contraction, unfolding just beyond the FED’s 2023 forecast horizon. The suggestive nature of the above questions reveals the direction of response. Effectively, an accelerated reopening pace of economies will also speed up the signal formation about the quality of the recovery, its endurance, lifetime and/or the fragilities that are exposed, leading to early growth disappointments.
Essentially, the message the chair of the FED, Jay Powell, bestowed on markets was that inflation unanchoring was a tail risk and FED policy would normalise earlier the moment incoming hard and survey-based inflation datasets deviate from the projected path. The FED lifted CPI and PCE readings for 2021 and 2022 but kept 2023 steady around 2.2% and 2.1% respectively. By the end of 2023, unemployment should reach 3.9%, as non-farm payrolls would boast a monthly average gain of 539k over the remainder of 2021, 286k over 2022 and 200k over 2023. The infamous dot plot conveyed an increased probability of initial lift-off at the end of next year as well as a strong probability that by the end of 2023, the FED’s hiking cycle would be well underway, and a third policy rate adjustment should be expected by Q1 2024. On June 16, the FED literally threw the pressure cooker scenario out of the window. They will not tolerate a ‘behind the curve’ set of complexities to deal with. The FED taught the market a lesson in leadership. Leveraged or margin-based speculative strategies received a loud and clear warning shot; free money for ever should not be taken for granted. First order reactions that stood out were the following:
Aggressive bull flattening of the US Treasury yield curve. The 2Y30Y interest rate differential encountered a multiple sigma (standard deviation) event, dropping by a whopping 23.5bp. 2-year rates surged towards 0.255% over the week, whereas 30-year rates dropped by 12.5bp to just above 2%, closing at 2.015%. The pivot of this flattening occurred at the 10-year point. 10-year rates stood status quo over the week, finishing at 1.44%. The value call made between mid-March and mid-May with 5-year rates 5-years forward above 2.5% has been vindicated, as we closed at 2.07% on Friday, June 18. Indeed, 10-year rates might start to settle within a comforting 1.25%-1.50% range. The average inflation targeting is heavily backward-looking and given the expected high volatility nature of future inflation prints might become totally residual in the rate setting process. Rate volatility will fluctuate on the amplitude of future non-farm payrolls data series.
The dollar index (DXY index) surged by 1.84% to close at 92.225. Further USD strength against the Euro might be in the offing, as ECB taper discussions might get postponed and policy normalisation is years away. The EMFX (JP Morgan Emerging Market Currency) index retreated by 2.33% closing at its 200-day moving average at 56.71. Given still attractive average real rate spreads between US and emerging market (EM) Local Currency government bonds, investors are given a second chance to enter or reinforce into a yield-enhancing EM bond sector.
5-year US real rates rose a hefty 22bp, shifting from -1.77% towards -1.55%: a rare sell-off intensity. 10-year real rates added about 9bp, to close at -0.80%. Both are still in deeply negative territory, but the corresponding inflation expectations or breakeven rates crumbled in the face of the FED’s roar. 5-year breakevens fell 7bp over the week but almost 40bp since mid-May, closing at 2.37%. 10-year breakeven rates finished at 2.24%. The FED anchors inflation expectations expressed through US TIPS. A range has been set. As stated last week, markets will focus more on the US labour market.
While assessing the longer-term impact of what happened over the past week, one is drawn towards the 30-year point of the US yield curve. The flattening push took this key rate close to 2.00%. I reckon one question is in order. Has the acceleration of US government indebtedness sealed the faith of long rates? Stated otherwise and capturing the message of Reinhart-Rogoff in the paper “Growth in a Time of Debt”, has the shift in gross (external) debt impacted the long-term growth potential of the US economy? ‘Fair enough’, the paper argues at the level of external debt. The moment gross external debt reaches 60%, it shaves of 2% of potential growth whereas an increase beyond 90% halves potential growth. At the end of 2020, the US external debt accounted for 102% of the country’s nominal GDP. The direction of indebtedness is up, as might be the impact on potential growth and possible the level of long-term US rates.
I was word counting for about 25 minutes into the Fed’s press conference, when I folded and decided to call it another day in the market. Inflation was beating labour handsomely as market watchers kept on asking the same questions relating to the high inflation prints over past weeks. Tiring. Yet, the messages Powell was giving were pointing to the importance of labour market health mainly achieved through a higher participation rate and improving labour conditions. Reaching for nuance and objectivity in narratives, that are created under pump and circumstance in TV studios broadcasted 7 by 7 across the world, is a near impossible feat. However, the market is always right. The messages above are testament. The labour repair over the next couple of months will set the tone in rate markets.
The recovery in European Government Bond markets hit a brick wall retreating 38bp closing at -3.18% year-to-date. The US yield curve bull flattening filtered through core EMU rate markets. The long end of the German curve adjusted by about 3.5bp, closing at 0.25%. German 30-year rates made a high on May 18 at 0.46%. What strikes is the aggressive flattening of the 10-year to 30-year German rate differential, suppressing by 10bp towards 45bp. A highly unusual movement to say the least. Italian, Spanish and Portuguese government bonds lagged an overall-supportive week for core rates. We welcomed the inaugural 10-year 0% coupon Next Generation EU bond. It got issued at 0.08% (called the re-offer rate) obtaining the label ‘attractive’ when compared to the German curve. The first EUR 20 billion broke well into secondary markets and everyone is looking forward to end-of-month new issuance. The only negative was that about eight market-making European and US financial institutions were disallowed from participating in the syndication. Reasons related to penalties struck over rates rigging over the past decade. At a time when liquidity has become a key risk factor in financial markets, it appears an odd decision as the banks in question paid litigation amounts and addressed governance issues.
European investment grade (IG) credit and high yield (HY) credit encountered stiff resistance and could not hold onto any gains over the week. The IG corporate bond sector lost 11bp, versus a modest 13bp retreat in HY. All eyes are set on global equity markets that featured an appalling close. As most of the summer optimism has been priced across sectors, one wonders how the credit risk premium will fare the moment US taper discussions intensify, or the shadows of the pandemic become longer.
The impact of the Fed’s hawkish tilt has been felt in USD returns as the strength of the US Dollar weighted on EMFX. The index for local bonds (JPM GBI EM GD) lost -1.90% in USD terms when returns were flat in EUR. The yield of the index increased by 6bps to 4.98%, while the spread of the index in hard currency (JPM EMBI GD) increased by 2bps to 336bps versus US Treasuries. The bulk of the spread widening has been felt in lower-quality names with the spread of sub-Saharan Africa increasing by 10bps during the week.
The bull run in Copper that started one year ago is showing some signs of fatigue. Copper went down 6% in one week and news flow was negative, with increasing focus from Chinese authorities on the price of metals. The National Food and Strategic Reserves Administration announced to release some copper, aluminium and zinc, making them available to manufacturers. State-owned enterprises were also ordered to control risks and limit exposure to commodities markets. They have been asked to report their futures positions to the authorities for review, in order to curb speculation in commodities markets.
Kenya raised USD 1 billion in a Eurobond sale. The book received more than USD 5 billion of firm interest for a 12-year bond yielding 6.30%. While it priced tight versus secondary (2032s were yielding 6.25%), the deal performed nonetheless on the secondary market in a similar fashion to the recent new Senegal issue in EUR, showing the strong appetite from investors for low-rated paper. While Kenya is expected to borrow around USD 7 billion in the Eurobond market over the next two years, the government stuck to the target amount despite oversubscription.
Costa Rica’s (rank 10/70 in our ESG ranking) economic, social and environmental progress is an example for the whole Central American region. Its fiscal situation remains however a critical vulnerability, as large deficits (fiscal balance -7.00% of GDP in 2019 and -9.1% of GDP in 2020) threaten these remarkable achievements. Improving public spending is a top priority, as public salaries are almost 50% higher than in the private sector and compensation of government employees accounts for more than half of total government revenues. The approval of the public employment bill in the first of two required votes this week, is part of the initiatives proposed by the government to adjust its finances in search for an agreement with the IMF on a USD 1.8 billion IMF program. The bill creates a new single framework for employment in the public sector and is now sent to the constitutional court for a 30-day review prior to a final second vote. The extremely slow legislative process in Costa Rica, has resulted in missed deadlines in the past. Whether the deputies respect IMF deadlines is a bigger hurdle than political support for the bill itself.
In South Africa, President Ramaphosa seems to be firming his grip on power and accelerating its reform drive. After mostly incremental reforms, two recent announcements are showing the government is having the upper hand on internal dissenters within the ANC to push for some flagship reforms. First, the President announced the lifting on a cap for embedded electric generation from 1MW to 100MW, in order to address the energy supply shortfall and the risk of load shedding that is weighing on growth potential. This is a surprise, given the fact the private sector had been lobbying for 50MW and the Minister of Mineral Resources and Energy had previously announced 10MW only, calling the 50MW cap some “noise”. Following the President’s announcement, the Minister swiftly announced it would also work with Eskom to “rapidly bring to fruition at least 1.6GW of largely renewable and private-sector funded generation projects”. Second, Minister of Public Enterprises Gordhan announced the government would sell a 51% stake in bankrupt South African Airways to a consortium made up of a private equity firm and an aircraft leasing company. The Minister had previously stated it would retain the majority control of the airline, which was a major constraint for any potential private investor. Whether this is the start of a new approach in which the government does not guard a controlling stake in its state-owned companies (over 700) is not clear yet, but it seems a taboo has finally been broken.
Over the past week the US central bank has confirmed its global monetary leadership. It happened totally in sync with President Biden’s message towards the G7, NATO, Russia and most importantly China that the US is not ready to stand back but prolong and even strengthen its global political leadership.
The bull flattening of the US yield curve was special and reveals fragilities across longer-term realised inflation and growth potential.
Bond markets have gone through a serious test since November 2020 but might come out with a vengeance. Investors should embrace the global opportunities on offer across DM and EM bond sectors.