Head of Fixed Income Strategy
Summary: Tomorrow's Georgia run-offs will be incredibly important for the bond market because their result can add to the case for reflation. The 10-year Breakeven rate is the highest in two years, and the US yield curve continues to bear steepen. Eventually, 2021 could be the fifth year in more than forty years in which US Treasuries will provide a negative annual return. In Europe, an extension of lockdown measures might boost European sovereigns' sentiment as the market expects more ECB stimulus. In the UK, Wednesday BOE's governor Bailey's speech might provide an insight into the possibility of negative interest rates.
Dear readers, Happy New Year! It won't come to a surprise to know that 2021 still looks very much like 2020. The risk of running into reflation, Brexit and the Covid-19 pandemic, remain topics that cannot be ignored yet.
Starting with the US, bond investors will need to pay attention to tomorrow's Georgia run-offs to determine whether Republicans or Democrats will take control of the Senate. A Democratic Senate will enable Joe Biden to enact comprehensive legislation on the economy, healthcare and the environment as proposed during his presidential campaign. In short, it implies a bigger stimulus package that will add to the already implemented measures, putting more pressure on inflation.
Consistent with the reflation story, the market expectations on inflation are the highest in two years. The ten-year breakeven is about to touch 2%, and the yield curve continues to bear steepen.
The reflation story is crucial for bond investors because it implies that the market will not be able to find shelter in Treasuries this year as long term yields rise. Since the '70, US Treasuries' provided negative annual returns only four years (see Figure below). Although long-term yields rose since August, they are still at a historic low level providing a tiny buffer to a fall in Treasuries' prices and making them more vulnerable to just a few basis points movement in yield.
The reflation story, however, isn't stopping the primary market from issuing new bonds. Today Mexico is offering 50-year dollar bonds, and three Asian companies are issuing USD green notes. After having issued a record $3.4 trillion in corporate bonds last year, borrowers look to continue to do so at the beginning of this year to secure cheap debt before yields rise.
In Europe, the focus will continue to be on a rise of Covid-19 cases and the direct consequences of a Brexit deal.
This morning we are seeing European sovereign yields falling with the Bund benefitting the most. It is becoming clear that although the vaccination program has started, it will take months if not, even a year to get the population immunized. It suggests that an extension of existing lockdown measures is very likely.
The auction of 10-year Spanish Obligaciones this Thursday will be important to assess the market appetite for peripheral assets. Ten-year Spanish government bond yields dipped below zero in mid-December. However, they closed in positive territory by year-end amid low liquidity and news concerning a new Covid virus strain. Suppose Europe sees an extension of lockdown measures. In that case, 10-year Obligaciones yields are likely to fall back below zero as the market believes that the ECB will endlessly print money until a stable path to recovery has ensued.
This morning, despite the Brexit deal, ten-year Gilt yields trade below 0.20%, pointing to investors still thinking that the Bank of England might cut interest rates below zero. The BOE's governor Andrew Bailey's speech this Wednesday might offer insight into whether negative rates are on the agenda for the next monetary policy meeting on the 4th of February, possibly giving another push to gilts.
Economic Calendar:
Monday, January the 4th
Tuesday, January the 5th
Wednesday, January 6th
Thursday, January the 7th
Friday, January the 8th
2024: The wasted year
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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.
