Head of Fixed Income Strategy
Summary: The reflation trade in the US and a hawkish Bank of England have inflicted painful losses to bondholders this week. Thirty-year US Treasury yields rose to the highest level in a year. In England, an unexpected message from the BOE pushed the Gilt yield curve higher. Investors holding Italian debt close the week happy as bullish sentiment arising from the possibility of a Draghi government pushed BTPs higher.
While investment-grade and junk corporate yields were stable this week, government bonds sent strong signals in the United States, United Kingdom and Italy. In this article, we look at this week's top events and attempt to understand what can come next.
US yield curve continues to steepen inflicting losses to bondholders
This week, the reflation story has picked up the pace. The 5s30s spread is the widest in six years, and 30-year yields are trading above 1.9%, the highest level seen since February 2020.
The nonfarm payrolls coming out today might give another push Treasury yields higher if the data surprises on the upside. If that were to materialize, the 30-year yields would rise to test their resistance at 2%.
Regardless of what will happen with the nonfarm payrolls today, we believe the yield curve is trading in an uptrend and will continue to steepen. To put pressure on US Treasury yields are the inflationary forces coming from easy monetary policies, fiscal stimulus and a possible pick up of the velocity of money later in the year.
Since the beginning of January, US Treasury bonds across the yield curve have reported an average loss of 1.35%. At the same time bonds with a maturity longer than 20-years have recorded a loss of 5.15%. As yields continue to rise, it becomes crucial to building a buffer against rising yields by seeking coupon income.
Gilts selloff amid hawkish Bank of England
Yesterday’s Bank of England monetary policy meeting surprised the bond market. Ahead of the BOE's press conference, the money market was partially pricing a rate cut this year with Gilts up to five years providing negative yields. Although the BOE adjusted the economic growth outlook down, the central bank acknowledged that the economy is heading for a rapid pick up due to a fast pace of vaccinations. It was enough to weaken expectations concerning further interest rate cuts and cause an immediate shift up the Gilt yield curve as well as a slight steepening.
Without more stimulus coming from the BOE, 10-year Gilt yields will rise to test the upper trendline at 0.5% of the trend channel they have been trading since August. Once they have broken above this level, they will find resistance at 0.65%. If that were to happen, ten-year Gilts would record a loss of 3.5%, or bigger if yields continue to rise. However, if there are unexpected delays with the vaccination program or the economy doesn't recover as fast as expected, a dovish sentiment might push yields down, but not lower than the benchmark rate at 0.1% representing a capped gain of 2%.
This strengthens our belief that Gilts have lost their risk mitigation purpose and that more downside can come from mixed BOE communication as well as from a fast recovery of the economy.
The “Draghi Effect” pushes the BTP-Bund spread below 100bps, the tightest since 2015
The spread compression trend between the BTP and the Bund has accelerated amid Draghi entering in the Italian political scenario. The 10-year BTP-Bund spread has tightened to levels previously seen in 2015, and now there is the potential for it to tighten further to 75bps, a level previously seen in 2010.
Yet, the market is losing focus, because while the 10-year BTP-Bund spread tightens, longer maturities are experiencing a more significant upside. Since the beginning of last week, the yield on 30-year BTPs has fallen by 18bps providing a capital appreciation of around 4%. We Believe there is room for the 30-year BTP-Bund spread to tighten as much as 120bps contributing to another capital gain of more than 4%. In the long-term, the difference between ten and thirty-year spreads will diminish, making appetible for Italy to increase issuance in the long part of the yield curve. It is then that the country might consider issuing BTP with maturities of more than 50 years.
2024: The wasted year
Markets are driven by election optimism, overshadowing growing debt and liquidity concerns. The 2024 elections loom large, but economic fundamentals and debt issues warrant cautious investment.
As US economic slowdown hints at a shift away from exceptionalism, USD faces downside with looming Fed cuts. AUD and NZD set to outperform as their rate cuts lag. JPY gains on carry unwind bets and BOJ pivot.
Amid AI and obesity drug excitement, equities see varied prospects: neutral on overvalued US stocks, negative on Japan due to JPY risks, positive on Europe. European defence stocks gain appeal.
With the economic slowdown, quality assets will gain favour, especially sovereign bonds up to 5 years. Central banks' potential rate cuts in Q2 suggest extending duration, despite policy and inflation concerns.
Commodities poised for rebound. The "Year of the Metal" boosts gold and silver, copper awaits rate cuts. Grains may recover, natural gas stabilises. Gold targets $2,300-$2,500/oz, copper's breakout could signal growth.
Markets are driven by election optimism, overshadowing growing debt and liquidity concerns. The 2024 elections loom large, but economic fundamentals and debt issues warrant cautious investment.
As US economic slowdown hints at a shift away from exceptionalism, USD faces downside with looming Fed cuts. AUD and NZD set to outperform as their rate cuts lag. JPY gains on carry unwind bets and BOJ pivot.
Amid AI and obesity drug excitement, equities see varied prospects: neutral on overvalued US stocks, negative on Japan due to JPY risks, positive on Europe. European defence stocks gain appeal.
With the economic slowdown, quality assets will gain favour, especially sovereign bonds up to 5 years. Central banks' potential rate cuts in Q2 suggest extending duration, despite policy and inflation concerns.
Commodities poised for rebound. The "Year of the Metal" boosts gold and silver, copper awaits rate cuts. Grains may recover, natural gas stabilises. Gold targets $2,300-$2,500/oz, copper's breakout could signal growth.
