Q2 Outlook: Why sovereigns are Q2’s investor favourites
Fixed Income Strategist
Summary: The Federal Reserve finally reacted to the escalating likelihood of a global recession with a sharp dovish turn last month, joining the ranks of the European and Chinese central banks. This is unhappy news for already-fragile EM and corporate bonds, especially in the high-yield space, but it augurs well for sovereigns.
We believe that this global policy panic will play in favour of global sovereigns. Credit spreads will also be supported, but investors should remember that dovish central bank policies may prolong the late-cycle period. They will not, however, be sufficient to entirely avoid the recession we believe is coming in Q4’19 or early 2020. This means that while credit valuations will be supported for longer, credit risk will remain very high; in this context, investors should stay cautious and avoid taking on unnecessary risk, especially in the high-yield and emerging market spaces.
Dovish Fed = strong sovereigns
The global policy panic sparked by the December sell-offs has seen the Fed turn away from quantitative tightening and its own rate hike schedule. As such, we will see more of what we saw before Powell: a continuous flow of resources aimed at incentivising investment, which in return does not pick up, leading inexorably towards recession.
A dovish Fed is good news for bond investors even amid muted economic growth. Treasuries will gain from the unconditional support even though if it is now clear that recession is coming. In the wake of the March Federal Open Market Committee meeting we have seen yields on the mid-to-long part of the curve falling faster than short ones, meaning that the spread between the five- and two-year Treasury yields has fallen to -6.6 basis points, which is the lowest we have seen in more than a decade. More importantly, the spread between 10-year Treasuries and the monthly T-bills went also negative, indicating an inversion in the mid-long part of the curve as well.
Besides being a sign of a recession, an inversion between 10-year and six-month yields also indicates that Treasuries and high-quality credits with maturities between seven and 10 years become particularly attractive as valuations will be supported by the Fed, which will soon need to replace mortgage-backed securities in its balance sheet with Treasuries matching the same maturities.
Things are going to be different in the credit space. As the longer part of the yield curve inverts even further and we enter recession, we will start to see investors selling off risky assets, and thus a quick worsening of both IG and HY credit spreads. While high-rated credits may in some cases represent a buying opportunity, we urge investors to remain cautious within the high-yield space. A recession might push default rates to levels unseen since the crisis.