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STATE OF AFFAIRS
Academic research has decomposed observable nominal long-term yields into the expected path of short-term real rates and the extra term premium. The latter is essentially the extra return bond investors require to compensate for the risk of holding onto a long maturity bond. Under stable inflation conditions, the term premium is influenced by the expected increase in short rates. The increase from 2.10% to 3.45% of 30-year US yields between July 2016 and November 2018 was mainly due to rising expectations of short-term interest rates, as the Fed normalised policy rates. Inflation was persistently undershooting back then. Today, the term premium will not increase as a result of expectations of rising short-term rates. Building an OIS yield curve starting from the shortest rates (OIS or overnight index swap rates), we get a 30y US rate of 1.02%. For Germany we get a 30y rate of -0.03%. The current nominal 30-year US rate of 1.57% should compensate you for expected inflation over the holding period. Well, it doesn’t, as 30-year inflation expectations closed on Friday at 1.86%, putting the 30 year real at -0.29%. We repeat that this condition is persistent and will worsen, pushing real 30-year rates deeper into negative territory as was the case in the early 1950s and during the 1970s. The FEDs asset purchase program is reducing the free-float of US Treasury bonds fast. The free-float is constructed by subtracting from total outstanding US Treasuries the securities held outright by the FED and the Treasury holdings of foreign official institutions. Currently, that free float, between 30% and 40%, still allows for upward pressure on the term premium, as expectations of reflation (enforced forward guidance and flexible average inflation targeting by the FED on top of increased deficit spending under Biden), exerts upward pressure in the short term. A revisit of the 1.90% – 2.10% area is a possibility with a slim probability attached though. However, it would also offer an enormous buy opportunity as this participant assesses that continued quantitative easing (shrinking the free float of high-quality risk-free bonds) and the welcome system-clearing effects generated by negative real rates will eventually push 30-year nominal rates below today’s levels. A revisit of the early June 2020 1.75% level in 30-year US rates following a Biden win in November should present a first opportunity to increase long end exposure. If we ever get there, of course. It should be evident that, next to central bank policy influencing term premia, non-monetary determinants will hold long-term rates at bay. Those determinants are potential real economic growth rates that still trend lower, demographics that support demand for bonds, and portfolio risk preferences that support flight to safety by institutional investors under rampant financial asset inflation.
In Europe, 30-year government bond yields for Italy, Spain, Portugal and Greece dropped to historically low levels over the past week. Italian 30-year rates closed at 1.61%. Spanish and Portuguese 30-year rates dropped below 1.00%! Greek 30-year rates settled at 1.35%. Who would have predicted with Greek 10-year rates above 30% in February 2012 closing at 0.86% on Friday? Clearly, the intra-EMU rate convergence at the long end is accelerating. The negative 10 basis points (bp) 30-year German bond yield is acting like a black hole. When the free-float in US Treasuries is reducing steadily, the free-float of German Government bonds has dropped well below 10%! Some studies show that the free-float has dropped to around 3% whereas it was still around 15% over 2017. The combination of lesser bond issuance by the German debt agency (as a result of budget surpluses during pre-COVID times), unabating purchases by central banks and increased interest by buy-and-hold investors for bonds with the highest collateral value has effectively created an enormous scarcity. That anchors the reference German 30-year point around, hard to comprehend, zero, and currently negative levels. The Netherlands at -0.03% and Switzerland at -0.33% are the two other countries that can fund themselves at negative rates (or with a small profit so to speak) over a generation. The increasing supply given borrowing requirements caused by important government deficits will be met be a wave of investor reinvestment willingness and sustained and growing aggregate central bank purchase programs. Over 2021, we face a net negative supply year. The supply argument is a false argument calling for higher rates.
On a more general note, we observed markets pricing of a Biden ‘Blue Sweep’ victory. In expectation of a Democratic House + Senate US political landscape, 30-year rates pushed 8.5bp higher to 1.57%, gold recovered 1% to USD 1930 and the broad USD index weakened about 0.50% with EURUSD finishing at 1.1825. 30-year US inflation expectations rose to 1.86%, clearly attempting to cross the 2.00% level over the next quarters. A Democratic presidency is expected to run an aggressive government spending race over 2021. That translated into a performance spurt for the following equity sectors: renewables (+9.5% w/w), infrastructure (+7.2% w/w) and China equity (+5.2% w/w). We do repeat that asset inflation is a vicious circle, whereby higher equity valuations go hand in hand with increased interest in long end risk free, high quality bond investment. The bond-equity return correlation remains solidly negative and long end AAA government bonds diversify risk effectively in balanced portfolios. Accommodative monetary policy and modest inflation expectations cement this negative correlation backdrop.
Heavy Treasury supply alongside the high probability attached to a Biden presidency delivered a more pronounced bear steepening of the US Treasury yield curve. Two-year rates backed up 2.5bp to above 0.15%, 5-year bonds added 5bp to 0.34%. The longer end suffered more, with 10-year notes finishing at 0.775%, up 7.5bp, and 30-year rates, as stated, adding 8.5bp to 1.57%. The picture across real rates in TIPS (inflation linked US Treasuries) was totally different. US 10-year TIPS dropped 1.5bp in real rates towards -0.96%! US 30-year TIPS added a mere 3bp. Essentially; over the past week, investors in US TIPS were insulated from the upward nominal rate adjustment that weighted on performance. We expect that such market outcomes will occur more often. The path of least resistance is for real rates to become more negative, as long-term scarring of the US economy becomes more visible and evident.
European government rates did not correlate with the US at all. Once again, German rates stayed put around -0.53% and -0.10% on the 10-year and 30-year point respectively. Italian 10-year rates shed 6bp towards 0.72%, versus Spanish and Portuguese rates dropping about 4bp towards 17bp and 18bp. That propelled year to date (YtD) performance to +4.28%. 2020 will become a solid vintage for European government bonds. Just as a reminder, 2006 was the only year since 2000 which posted a small negative result of -0.25%. The near-perfect track record remains in place.
Across European investment grade and high yield bond sectors, spread tightening was the norm. Investment grade corporate bonds zoomed in on the 110bp spread level, with an index yield pushing around the 0.50% level. With total return over 2020 reaching 1.26%, it does not set us up with high confidence that 2021 would bring a positive result. Spread levels become challenging, as one wonders with about 22% of the universe in negative yield territory, where the marginal buyer, leaving the ECB out of this equation, can be found? Are we redefining the notion of credit risk premium? With Itraxx Main index showing the average 5-year CDS credit spreads close to 50bp we wonder if 2007 levels around 25bp can be reached? Back then, it was CDS selling from structured product manufacturing that was responsible. Private product structuring has been replaced by public central banks’ purchase programs, compressing credit spreads for the select club of large corporates that operate on public capital markets. When you observe that European banks tighten the lending standards for small and medium corporates, with little to no access to deep capital markets, one questions how far moral hazard must run. The European capital markets union project should allow for a level playing field when it comes to funding opportunities. Reality is different and harsh. Across high yield markets, the compression is running into more and more resistance, as investors prepare for a less supportive 2021. Spreads did fall below 4.50% again, putting YtD performance at -1.52%. We repeat that with a yield around 3.80%, we just might take the sector into the positive by year-end.
The week has been constructive for Emerging Market (EM) debt, as the blue wave scenario in US elections is increasingly being priced in risk assets. Returns were mostly driven by EM sovereign credit and EMFX. Spreads in local debt (GBI-EM) were flat to 3.82%, while hard currency (EMBIG Diversified) sovereign spreads tightened by 20bps. The index exhibited a compression in spreads, with Sub-Saharan Africa (-49bps) outperforming IG spreads (-15bps).
EMFX gained 0.38% vs USD and 0.27% vs EUR during the week. The Mexican Peso was the best performer vs EUR (+2.29% spot return), confirming its high beta to US stocks. The Peso did outpace all other currencies, with other best performers being the Thai Baht and Korean Won with +1.09% and +1.07% respectively. The worst performers were the Turkish Lira (-3.06%), the Jamaican Dollar (-2.07%) and the Iraqi Dinar (-2.06%).
The Turkish Lira suffered from the Turkish government’s hawkish stance and implication in the conflict between Azerbaijan and Armenia in Nagorno-Karabakh. Turkey also opportunistically issued USD 2.5 billion on the Eurobond market, at a yield close to Nigeria for the same maturity (5y). The issue attracted lots of interest with books above USD 6.3 billion, but struggled to perform on the secondary market.
On the inflation front, data released this week showed a mixed bag. In Brazil, consumer prices rose to 3.14%, fuelling speculation that monetary tightening may start, especially if public spending runs out of control. In Chile, consumer prices rose twice as fast as expected. Early pension fund withdrawals boosted consumption. Probably the biggest surprise came from Hungary, where inflation dropped to 3.4%. For monetary policy, this sharp disinflation gives some breathing room. Local bonds reacted positive to the news and rallied 25bp.
In India, the newly appointed Monetary Policy Committee with three new members, met on 7-9 October and was very instructive. The bank held repo rates unchanged at 4%, but managed to be very accommodative. It announced a set of regulatory and liquidity measures to help central and state governments borrow from the market, and incentivise banks to lend more to the private sector. While it shows the growth objective is now the top priority, the press released specified that it will keep a lid on risk-free rates: “While [the augmented borrowing programme for 2020-21] has imposed pressures on the market in the form of expanded supply of paper, the RBI stands ready to conduct market operations as required through a variety of instruments to assuage these pressures, dispel any illiquidity in financial markets and maintain orderly market conditions”. It has been welcomed by bond investors who were concerned by a stubbornly high inflation, and the fact that public sector borrowing is on a steep path, increasing from 9% of GDP in 2019 to more than 16% in 2021 according to budget.
With OECD central banks policies stuck at the effective lower bound and purchase programs leading to net negative supply conditions over 2021, our convergence call for long end rates stands firm. The combined impact of monetary and fiscal reflation efforts might deliver short-term steepening pressure. However longer-term scarring of real economic growth potential inflicted by the COVID-19 pandemic will exert downward pressure on term premia. Demographics and accelerating financialisation will close the debate around a sustained rise of nominal long-term interest rates.
Indeed, financialisation, or the tendency of corporates not to invest in productive assets but financial assets, is propelled. Central banks, even as they aspire towards rational objectives, represent the oil on this financialisation fire. Central banks have become prisoner of their own policies, as a respected market strategist explained last week. In the meantime, the world is our oyster in bonds and diversified exposure across developed market and EM bonds still offers decent expected returns.