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STATE OF AFFAIRS
The first week of 2021 has stirred up emotions in bond land. The end-of-year agreement in the US congress on a USD 900 billion fiscal stimulus program in combination with the small surprise on the Georgia runoff results have been lifting US long rates aggressively compared to the stable conditions that were present over H2 2020. A unified Democratic instead of a divided Congress leads to a narrative that calls for big government. Expansive government spending will spur demand given a sustained rise in disposable income. Democratic leadership, aiming to reduce polarisation across US citizens, might opt for repetitive hand-outs instead of one-off, temporary pandemic-related financial support. By summer, with vaccination programs closing in on herd immunity levels, consumption intensity might accelerate. Savings will get depleted in order to celebrate re-conquered freedom. US inflation, in combination with positive base-effects due to deflationary 2020 conditions, might hit 2.5%+ readings over 2021. A panic in US bond markets can result in 10 year US Treasury rates hitting 2.00% according to some market observers. Plausible though the sequence of above events might read, I question this scenario. The counterarguments relate to the regime shift we often discussed last year. A revisit is in order. We will highlight secular currents that will become visible over time.
The regime shift occurs at the level of monetary-fiscal cooperation and collaboration. Over the past 50 years, monetary policy essentially operated counter-cyclically. Central bank independence was never questioned. Fiscal policy, more often than not, was pro-cyclical. The pandemic has been the catalyst that is altering this framework. Beyond the pandemic, the challenges that require remedies are structural of nature. A collaborative model is a necessary condition in order to tackle and increase the probability of success of the structural challenges below.
Sustained fiscal policy initiatives, with monetary policy in unconditional support, are required in order to:
Allow the global economy to transition towards a sustainable ecosystem. In 2018, the UN’s Intergovernmental Panel on Climate Change called for a 50% cut in annual global emissions by 2030 and hit net zero carbon by 2050. The burden on OECD countries would be even higher and net zero should be reached by 2040.
Reformulate growth objectives as an engine of prosperity, as chasing maximum growth is clashing with the finite capacity of the earths’ resources. The rampant globalisation has already been hitting the brakes over the past 3 to 4 years. However the source was linked to the U-turn initiated by the outgoing US President destroying the multilateral cooperation model in climate, economic and military alliances. If the global economy is to achieve inclusive and sustainable progress, business and household investment and consumption patterns will require remodelling.
Reduce labour versus capital compensation inequality. In order to save capitalism, labour compensation should rise in line with merit, not necessarily because of privileges. Health care sector nursing and medical professionals combatting the pandemic are genuine heroes that deserve, on average, far better financial rewards. The education sector comes close in second place.
As long as financial markets remain subject to detrimental boom-and-bust cycles, solving these structural issues becomes complex. Even if we have learned how to survive a boom-bust cycle its detrimental impact is clear. Most of the time capital allocation gets distorted to levels that require more monetary and fiscal intervention in order to rebalance. Addressing imbalances originating out of financial markets can be labelled as a waste of energy. A bust in US Treasury markets can be avoided. A fruitful Powell-Yellen collaboration should seal that objective. At this juncture the FED’s balance sheet holds 30% of all outstanding US Treasuries. The FED’s balance sheet anchor is strong. Expect FED QE to surprise in size and duration over the next couple of years in order to allow fiscal initiatives (including a realistic Green New Deal) to unfold. The FED will limit the rise in funding cost for the US Treasury department. An inflation surprise will not spook US bond markets but, if anything, push US real rates deeper into negative territory. Inflation expectations have already risen substantially with 3-year break-even rates (inflation expectations) close to 2.4%! A lot is already in the market. 10 year US Treasury rates closed the week at 1.11%. The 10-year rate 1 year forward sits at 1.34%. So we are comfortable investing today in 10-year US notes, as long as the US 10-year rate at the start of 2022 plots below 1.34%.
A destabilising hiccup in US rates kicked off 2021. Over the first week, US 10-year rates rose by 20bp from 0.91% to 1.11%. The US treasury curve bear-steepened aggressively as 30-year rates spiked 23bp closing at 1.875%. US 2-year rates barely moved adding 1bp closing at 0.13%. Comparing what happened in US real rates leads to an almost opposite result. 2-year real TIPS rates dropped a whopping 21bp, closing at -1.98%. 10-year real rats rose about 10bp (or half the number inflicted on 10-year nominals), finishing at -0.97%. 30-year real rates rose by 15bp for a -22bp reading on Friday. A very rare market movement was witnessed over the past week i.e. we observed an inversion of the inflation break-even rates curve. The US bond market has and is prepared for a bout of higher inflation prints over the next 2 to 3 years. Our key value indicator for US bonds is the 10-year US Treasury rate 5 years forward. This indicator plotted at 2.04% before the weekend. With FED policy rates at the zero lower bound over the next 3 years, we detect value in 10-year US notes. QE taper discussions can be labelled as noise.
The German bund market resisted the US rates sell-off well, adding a mere 5bp on the 10-year point to close at -0.52%. The ECB balance sheet anchor is even stronger than the FED’s. Italian, Spanish and Portuguese 10-year rates were oblivious to the pressure and closed unchanged or lower by Friday. The Italian 10-year rate prepares to test the 100bp spread level to 10-year bunds closing at 104bp. 10-year BTPS dropped 2bp towards +0.52%. The Portuguese debt agency informed market participants that 2021 borrowing requirements would be far below market expectations. The 10-year PGB’s finished 4bp lower on the week at -0.02%, pulling away from 10-year Spain going out at +0.04%. The strong EMU rate convergence trend is not abating. The start of the Next Generation EU funding program in 2021 might be a catalyst that strengthens this trend. European inflation expectations received a solid lift as well. European vaccination programs must gain speed fast in order to limit disappointment. European integration (now ex-UK) grew over 2020. A successful EU inoculation process should be the top priority for the European Commission and European leadership.
European investment grade (IG) and high yield (HY) credit markets got off to a robust start relative to EMU government bonds. Over 2020 EMU government bonds beat European credit markets by a large margin, returning +5.15% versus +2.73% for both IG & HY sectors. Carry will have the difficult task in credit sectors to deliver the bulk of returns. Further spread-tightening in the European IG and HY sectors will require unabated ECB purchasing in the former and robust interest by institutional investors in the latter.
Emerging markets (EM) will continue to benefit from a powerful monetary and fiscal stimulus. They will lead the gradual recovery from the pandemic. Financing capacity and fiscal buffers will be the crucial factors for country selection.
EM’ debt levels have been affected by a combination of negative growth and the need for higher spending. Debt to GDP ratios have risen, but remain well below developed markets debt levels. A decreasing risk premium, a low rate environment and a weaker USD will lower the debt servicing costs for many EM economies. Notwithstanding the potential problems with vaccine availability and the challenging distribution of the vaccines in some countries, growth is expected to outpace developed markets growth during the recovery. Structural improvements in Central Bank credibility, combined with a shift towards fiscal consolidation contributed to a better convergence of long-term inflation expectations to the target, despite the negative impact of Forex (FX) pass-through last year.
‘Low for Longer’ makes EM sovereign debt an attractive solution. A well-diversified portfolio invested in local currency bonds with an average IG rating yields around 5% today, far more than investments in US or EUR government bonds, IG credit and even HY credit. From a historical perspective, absolute yields and spreads are close to the bottom. However real yields and spreads in local currencies are still at very attractive levels. Looking at the ratio of local currency yields to US treasury yields rather than spreads, we are still some 50bp above the highest level witnessed during the global financial crisis! We expect this risk premium to come down further.
‘A weak USD is good for EM FX’ is a general truth. There is indeed a compelling relationship between the value of the USD and EM FX. We believe that the bulk of easing is behind us, that growth will gradually pick-up and that FX volatility will return to its longer-term average. That is why we believe that EM FX will perform well. We do not adhere to a scenario of extreme USD weakness given its safe haven and reserve currency status.
Countries with high primary deficits, weak fiscal buffers, high debt levels or high debt servicing costs, will be vulnerable. Some countries have shallow local markets and have to rely on external financing while re-financing needs are at record high levels. They might face execution risks. That is why country selection is more important than ever before!
The Blue wave scenario finally played out and triggered a rise in US Treasury yields. The JP Morgan Emerging Markets Currency index slipped back below 58 to 57.77 (-0.26% during the week). The worst performers in EUR terms were South African Rand (-4.20%), on concerns over a new lockdown and adverse seasonality effect and Brazilian Real (-3.20%), on concerns regarding fiscal deficits after President Bolsonaro said it was not his fault the country was “broke”. The Polish Zloty was one of the best performers (+1.13%), despite comments from members of the Monetary Policy Council last week, signalling weaker currency ahead and possible rate cuts.
The new fiscal-monetary collaborative model will reduce the boom-bust intensity across financial market sectors. Solving structural issues, climate change and income inequality, becomes a top priority for political leadership in order to protect democracy and inclusive prosperity. A pre-condition for a successful implementation is stability of government funding conditions. Increasing inflation expectations are mainly translated through low or lower real rates.
US 10-year rates might become anchored around 1.00% just as 10-year German bunds seem to hibernate around -0.50%. Over the past 5 years, Japanese 10-year averaged 0.00%! Mission accomplished for the Bank of Japan. The ECB and the US FED do not adopt an explicit yield curve control policy, but current forward guidance and QE flexibility implicitly conveys yield curve control.