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By plotting US, German, Japanese, UK, Chinese and Mexican (USD) government yield curves we present some interesting conclusions in today’s letter. The above selection intently delivers a potent mix of developed market (DM) and emerging market (EM) countries that exhibit a broad and colourful pallette of various monetary and fiscal policies in the face of the global pandemic condition. Changes in their respective yield curves since the start of 2021 reflect next to differences in intensity also differences in control in monetary and fiscal policy.
First, we offer two broader messages and follow-up with some specific reflections presented by yield curve clusters.
At the top of the yield curve set we find Chinese Renminbi government bonds that from from 2.70% on 2-year rates, 3.20% on 10-year rates to 3.70% on 30-year rates. This yield curve rises in prominence as local currency Chinese government bonds obtain between 8% and 10% allocations across various global government bond indices. The Chinese central bank (PBoC) exerts high curve control in a semi-open market structure. The on-shore and off-shore exchange rate takes over the role of pressure valve between local and international investor interests. At the bottom of the yield curve set we encounter the German Bund curve. With 2-year rates at -0.72%, -0.35% at the 10-year spot and the 30-year rate back in positive territory at 0.21% we find a genuine European risk-free asset. Its role as risk-free asset has even strengthened over the past three months as distress across the three main political European institutions (Council, Commission and Parliament) has been running high. The obstructions in their governing effectiveness became visible across the globe as their track-record in combatting this 1 in 100-years health crisis has continuously deteriorated. The ECB has taken firmer control, promising increased QE activity over the following three months. The remaining PEPP envelope of just below EUR 1000 billion till March 2022 will be fully put to work. That might anchor the German yield curve over at least a one-year horizon. With a low reading of -0.75% at the 3-year point, the inversion at the short-end of the yield curve increases suspicion that the ECB might still use the traditional policy rate instrument. Indeed, it’s not a base case scenario, but deserves attention. The -0.50% level for the ECB Deposit Rate might not be an end station.
Up to the two-year point, each of the above countries, except China and Germany, have converged within a range of about 70bp! Mexico 2-year USD bonds trade at 0.55% versus Japanese 2-year JGB’s at -0.14%. the Above central banks cherish independence highly. All of them have adopted enforced forward guidance of policy rates in order to propel the success rates of reflationary policies. The moment we zoom in on the 10-year point, the picture exhibits a higher degree of divergence. What are bond markets conveying here? The answer is as straightforward as it is confronting. The world economy is recovering in an extremely asynchronous fashion. It’s as if respective vaccination speeds correlate highly with expected cyclical growth, employment and inflation recoveries. US exceptionalism is back. The USD will profit under asynchronous recovery patterns. The 75bp rise of 10-year US rates since the start of 2021 is an expression of the effectiveness of US monetary and fiscal policy. Many doubts still linger on UK policy effectiveness, but find their origin in Brexit uncertainties across main UK economic sectors. 10-year Gilts at 0.75% have steepened the Gilt curve but remain shy compared to the US.
When looking at clusters, at the bottom we find the German-Japanese yield curve pair. The Bank of Japan has confirmed its yield curve control policy mid-March. It allowed for a wider 25bp band around 0.00% for 10-year JGB’s. They also tapered their equity purchase intensity by dropping the Nikkei universe out of the purchase equation and sourcing equity within the broader TOPIX universe. Essentially, the Bank of Japan is playing another tune in a music list that sees no end. We can expect a similar attitude by the ECB over the next couple of years. The market is effectively not pricing in a tightening of policy any time soon. We do expect a lot of innovative tinkering across long-term funding operations, traditional and non-traditional instrument use.
The second cluster can be labelled as the Anglo-Saxon pair. The UK and US’ fiscal support geared towards demand support is lifting real growth prospects in a high 4% to 6.5% range. However, unlike the FED, the Bank of England is not on autopilot. It might increase QE intensity in order to keep accommodative financial conditions intact. That explains the subdued sell-off in 10-year Gilts compared to US rates. The key message remains that the ‘orderly US rate tantrum’ might have arrived in its last innings, as the gap with the above German-Japanese pair and the UK Gilt curve has widened. The attractiveness of US rates, especially on a USD hedged basis, is too compelling for global investors. Expect high US Treasury demand over Q2 2021.
The third EM cluster is defined by the long-term value that local currency Chinese and hard currency Mexican government bonds offer in a bond world deprived, on balance and on average, of yield. I picked Mexico and China, as both countries rely on credible central banks that prompt government to conduct proper macro-prudential policies. Expect sustained high demand in stable investment grade bond products on offer across both countries by an expanding international investor base for years to come. The Mexican government might have behaved in a more volatile way over the last three years of AMLO’s presidency. But, be aware that the head of Government of Mexico City, Claudia Sheinbaum, is destined to succeed AMLO. Claudia Sheinbaum is the natural successor to AMLO within the popular Morena movement. Mexico might outpace the US in the election of a first female president. Her curriculum is outstanding.
As we are heading towards the close of Q1 2021, we observe some interest in US Treasuries. 10-year Treasury rates dropped 6bp, closing at 1.67%. More importantly, the 10 to 30-year rate differential dropped another 3bp to finish at 70bp. US inflation expectations rose across the maturity spectrum. All break-even rates reached new cycle highs. 2-year breakeven rates rose 10bp towards 2.72% whereas 10-year and 30-year breakeven rates rose 5bp and 4bp respectively. Even if US nominal rates dropped last week, US real rates dropped even more!
European Government Bonds (EGB’s) put in their best weekly performance for 2021. The JP Morgan EMU government index gained 47bp to recover towards -2.03% year to date. The 10-year rate complex across EMU countries dropped by 5bp to 6bp. The ECB QE bid is working its magic. The tug of war between reflationary hopes, putting upside pressure on rates, and the stubborn ECB PEPP buying program is in full swing. Vaccination progress is in order in for reproduction figures to fall below 1 again. That will become the key arbiter deciding over the direction of rates over the short term.
European investment grade and high yield corporate bonds booked both about 20bp in the weekly performance tables. Year-to-date, investment grade credit sits at -0.79% versus +1.19% in high yield. Very little newsflow over the past week. What has become obvious is that almost all companies start issuing green or sustainability-linked bonds. Clearly, all CFO offices have caught up with the prospectus requirements and selection of independent advisors in order to receive a market green light for ESG issuance. Investors should become vigilant in order to separate the wheat from the chaff.
The yield of the emerging market local currency index (GBI-EM) rose 12bp to just above 5.00% this week. The Emerging Market Currency Index lost 1.15% this week, whilst currency volatility rose to the 11-handle. The Mozambique Metical (+4.00% in EUR terms) was the star of the week, followed by the Paraguay Guarani (+2.10%), and the Jamaican Dollar (+1.60%). Turkish Lira (-10.30% in EUR terms), Brazilian Real (-3.05%) and Colombian Peso (-1.60%) ended the week with the most negative returns.
The Turkish Lira depreciated by more than 10% and long end local bonds widened by 500bps after the market-friendly governor Naci Agbal of the Central Bank of Turkey (CBRT) was fired during the week-end. While the new governor (Sahap Kavcioglu), the fourth in two years’ time, promised to keep the simplified rate framework (using the 7d repo rate as the main policy tool) and fight inflation, confidence in an independent monetary policy has been broken. The balance of payment is likely to stay under heavy pressure and inflation pressures are likely to intensify due to a mix of base effects, higher oil prices and currency depreciation.
The Mexican Central Bank (Banxico) kept, in a unanimous decision, its policy rate unchanged at 4.00%. This time the statement made no reference to a “pause”. The Banxico board plans to be on hold for a longer period and signalled that risks to the inflation outlook are upward biased. Rising US yields, AMLO’s plans to increase pensions in the non-contributive pillar whilst reducing the retirement age and the court suspension of the government’s new electricity law that aims to strengthen national power company CFE, have all contributed to underperformance of Mexican Government Bonds in recent weeks. As the sell-off in nominal yields outpaced the CPI increase, investors found shelter in shorter-dated inflation-linked bonds. Clearly, local debt underperformed hard currency debt during the move. Time to re-enter the long end of the local curve with MBONO 2047 at 7.95% ! We expect that the Mexican Peso will be protected, as it is backed by one of the most careful emerging market central banks.
The IMF’s Executive Board this week conveyed broad support for the general allocation of Special Drawing Rights (SDR) up to USD 650 billion. The move provides additional liquidity to the global economic system by supplementing the reserve assets of the Fund’s 190 member countries. An SDR is an international reserve asset created by the IMF to supplement the official reserves of its member countries. “By addressing the long-term global need for reserve assets, a new SDR allocation would benefit all our member countries and support the global recovery from the COVID-19 crisis,” IMF Managing Director Kristalina Georgieva said. The SDR increase will substantially boost the reserve position and external liquidity position of many EMs.
Global bond markets are boxed in between the German yield curves and robust emerging market government yield curves such as China or Mexico (USD curve).
We detect three clusters that exert high attraction to yield curves in their close neighbourhood.
The German/Japanese cluster puts downside rate pressure across EMU government bonds. The periphery countries benefit most. Probabilities are on the rise that the German curve exhibits Japanese rate features. Low volatility is the least harmful… Low inflation expectations are to be avoided at all cost.
The US yield curve imposes gravitational forces across Australian and New Zealand government rates. UK Gilt rates might converge towards US rates. The latter might of course adjust lower and establish convergence.
The emerging cluster centers around China and Mexico. Gravitational forces are weak and convergence strategies will require higher central bank credibility across EM government bond markets. In addtion, responsible fiscal policies are required in order for rates and currency volatility to drop to a level that incites higher allocations.