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STATE OF AFFAIRS
Many market participants looked surprised when US Treasury rates tanked on Thursday, April 15. Despite a series of strong economic indicators, the rate on US 10-year notes went from 1.70% on Tuesday and hit a 1.527% low during Thursday’s session. With a headline month-on-month spike of +0.6% for US CPI, representing a +2.6% year-over-year inflation print, tensions ran high for a break to the upside in US rates at the long end of the yield curve. The Thursday release of weekly Initial Jobless Claims posted a surprise drop towards 576k, against consensus estimates of 700k, next to robust Retail Sales at +9.8% Month-over-Month should have inflicted damage across global rate markets. However, the market did not budge and started to rally against all odds. In this letter I want to shed some light on the underlying drivers that shape rate volatility as well as Treasury demand. We will list the demand drivers as well as revisit the structure of outstanding stock of US Treasury bonds. Some interesting results come out. Again, the purpose is to shed some light on the complex equations that shape yield curves. Macro-economic indicators only represent a couple of pieces out of 100+ puzzle. Metaphorically, we deal with a puzzle with a lot of blue sky and sunlit water reflections.
A first positive US Treasury demand factor is located within the US defined benefit pension fund sector. A report was issued on Thursday, informing the public that the funding status of the 100 largest US corporate defined benefit pensions plans improved towards 98.4% by the end of Q1 2021. The Milliman 100 PFI (Pension Funding Index) is less than 2% away from full funding at 100%, with the deficit declining by almost USD 250 billion since September 30,2020. This sharp rise in funded ratios is resulting in a high demand for Treasuries and long-duration STRIPS (Separate Trading of Registered Interest and Principal of Securities). Over Q1 2021 the stock of outstanding principal STRIPS rose by USD 22 billion, a record increase. This high demand, among other factors, has pushed the interest rate differential between 10-year and 30-year US rates lower by about 15bp over the past month and a half. One should expect continued robust pension demand into STRIPS and long maturity paper (Treasuries & Investment Grade [IG] credit). In the meantime, the street narrative prepares the market for continued gains in equity between 5%, and up to 10% over the remainder of 2021. Pension funds do not care what the rest of the year might bring. There is a sigh of relief that 100% funding ratio is near and, on balance, US pension funds will want to increase the probability of remaining near this funding level by increasing their exposure to risk-free government bonds or high-quality long maturity IG corporate bonds. At this juncture, our own research into return correlation sees persistent negative US bond-equity return correlation as monetary policy remains highly accommodative and a de-anchoring of inflation is not a base case scenario. So, the moment US equity might lose some of its astonishing momentum, it will be to the benefit of US Treasuries.
A second positive condition in favour of US Treasuries is the yield pickup that non-dollar funded investors can achieve by selling home currency sovereign bonds and buying Treasuries with a short-term FX hedge. For German, UK and Japanese investors, this condition is currently at its highest level since 2015. For Japanese and German investors, 10-year US Treasuries offer between 100bp to 120bp in yield pick-up over 10-year JGB’s or Bunds after adjusting for a 6-month FX hedge. For 10-year GILT investors, the pick-up sits around 60bp when repositioning in 10-year US notes.
The relative scarcity phenomenon present at the longer end of the US yield curve is a third condition that might put a brake on upside rate pressure. End of March 2021, the total Treasury issuance, including Treasury short-term Bills, stood at USD 21.7 trillion. T-Bills represent 20.3% of that amount, whereas nominal Treasury bonds take 66.7% and inflation-linked issues 6.5%. This top 3 consumes 93.5%, aside from other less important Treasury paper categories. The respective FED QE rounds over the past 12 years have shifted the ownership towards the FED balance sheets as follows: the FED holds 6.5% of T-Bills, 28.9% of US nominal bonds and 23.2% of US-inflation linked bonds. The interesting bit comes next. The total outstanding nominal Treasuries (66.7%) sees 9.5% below 1-year, 31% in 1 to 5-year notes, 13.6% in 5-10-year maturity bucket and only 12.5% in maturities longer than 10 years. The tilt is towards shorter-maturity issues. The average maturity of pure US nominal Treasuries is about 7.2 years on a total outstanding of USD 14.5 trillion end of March. Thus, the long end, 10-year+ represents ‘only’ USD 2.7 trillion, of which the FED owns USD 1.02 trillion. In percentage terms, the FED owns 37.8% of 10-year+ Treasuries. The point I make is that the free float of long US Treasuries with maturities above 10 years is modest in a world that craves yield. That explains the sudden high success delivered by the auction of 30-year paper on April 13. The moment end-investors detect value, the impact is ‘unexpected’. For completeness, the biggest sellers of US Treasury bonds over the sell-off months of February and March were almost all registered in the Cayman Islands… Yes, the sellers that drove US yields higher came mainly from the ‘fast money hedge fund sector’.
US Treasury rates saw high buying interest over the past week. 10-year Treasury rates dropped 8bp to close at 1.58%. The 2-30-year interest rate differential closed the week at 211bp. I mentioned a target high of 215bp about a month ago based on previous steepening episodes. This QE controlled steepening is effectively running into high resistance. The damage inflicted by the pandemic to the global and US economy is still a subject of high debate. Interestingly, over the past week, the market-induced pricing of the first policy rate hike by the FED shifted from December 2022 to April 2023. The FED will need to put even more effort into explaining that short-term economic indicators are very volatile in early recovery situations. When looking at US capacity utilisation or labour market participation indicators (or longer-term indicators) one is realizing that challenges are steep and multiple.
European Government Bonds (EGB’s) eased another 19bp. Year-to-date damage is deepening towards -2.82%. Over the next couple of weeks, the sector will receive some support as redemptions and coupons payments are important. Including a proper ECB intervention buying some EUR 23 billion of EMU government bonds across PEPP and APP programs, we can expect further rate consolidation. The latter should also support valuations across Italian, Spanish and Portuguese government bonds. Expect continued intra-EMU rate convergence on the back of strong forward guidance and QE intensity willingness expressed during next Thursday’s ECB meeting.
In European spread products, I cannot announce any significant changes. European high yield added another 15bp to the performance tally, cruising towards a +2.20% year-to-date result. IG corporate bonds slipped a modest 7bp, ending the week at -0.75% for the year. Primary markets remain vibrant. Funding conditions remain highly accommodative for European (and by extension) large cap global corporates.
The emerging markets (EM) local currency performed well last week. The yield of the EM local currency index (GBI-EM) stabilises around 4.88%, whilst the EM Currency Index gained 0.9%. Currency volatility showed a mild drop from 10.50 to just below the 10 handle. Despite newly imposed sanctions by the Biden administration on Russia, the Russian Ruble (+1.85% in EUR terms) was only beaten by the South African Rand (+2.10%) and the Mozambique Metical (+11.4%). Paraguay Guarani (-3.50% in EUR terms), Jamaica dollar (-2.60%) and Uruguay Peso (-1.00%) posted the worst negative returns.
China’s real GDP growth increased to +18.3% thanks to favourable base effects. First quarter 2021 GDP however, surprised to the downside at +0.6% QoQ, one of the weakest quarters ever. Activity data were mixed in March, with slowing industrial production, services and fixed asset investment, while retail sales accelerated. All eyes are on Huarong Asset Management, as investors have been doubting the distressed state-owned enterprise could face an upcoming CNY 2.5 billion bond repayment due this Sunday. We are still waiting for the details on its restructuring plans after the company missed a deadline to report its annual earnings.
Yields on Brazilian local currency bonds kept on rising. The combination of the dire state of fiscal accounts alongside a near-term breach risk on the constitutional spending cap and a President that compares Covid-19 casualties to “some spilled milk” has worked as a toxic cocktail. Since the start of the year, yields on 10-year bonds spiked 250bp to around 9.50%. Brazilian 10-year rates fluctuate close or just above yields on South African Rand 10-year bonds. We expect the Banco Central to raise the overnight Interest rate by 1% to 3.75% at the next meeting, scheduled for May 5.
Brussels rejected a demand by Montenegro’s new government to help re-finance a USD 1 billion Chinese loan for an unfinished highway project. The most expensive highway in the world, which is being built by the Chinese Road and Bridge Corporation and which was ordered by the previous Montenegro government, has plunged the EU accession candidate into a debt crisis. Despite the fact that combatting Chinese influence in the region could be an opportunity from a geopolitical point of view, it is doubtful that a majority of EU citizens accept to use taxpayers money to help repay a Chinese contract. Bonds, issued in December last year, with a 7 year maturity, have lost 165bp since launch.
In bond land things are never what the public at large thinks they are. The preferred habitat theory is often forgotten. Yet, the combined impact of institutional investors and central banks cannot be underestimated in the control they exert on respective parts of the yield curves at any moment in time.
Today, interest in US Treasury bonds has increased. Pension funds have detected long-term value as well as protective diversification value. Non-dollar investors can arbitrage towards US government bonds increasing the longer term value of their portfolios.
The maturity structure of US Treasuries is often overlooked. The average duration is modest compared to other OECD countries. That supports current valuations and keeps longer term rates at bay. Any move by the FED towards an operation twist (increasing QE purchases towards the longer end of the yield curve) over the remainder of 2021 could surprise many market participants with its impact on driving long term rates lower.