Head of Fixed Income Strategy
Summary: This week, US Treasury yields' direction will continue to be a focus amid interest rates decisions in China, Russia, Canada and Europe. We believe that any rally in US Treasuries will be short-lived as the macro backdrop continues to strengthen, pushing inflation expectations higher. The only level worthwhile monitoring is 2% in 10-year yields. At that point, a selloff of risky assets is likely and foreign demand will grow substantially, posing a strong resistance level to yields. The PBoC meeting tomorrow will set the tone for the Asian market after Huarong's fallout. The deleveraging and accommodative efforts of the PBoC will favour long-term credit investors despite default risk remaining high in the short term. In Europe, the ECB cannot disappoint at Thursday's meeting because the bloc's inflation expectations remain below target. The central bank will need to make sure that it is using all possible tools to keep financial conditions favourable. Indeed, increased purchases under the PEPP program didn't seem effective in limiting the rise of European government bond yields.
(1) US Treasuries: the calm before the storm
Last week, as I watched US Treasury yields falling, I remembered Jim Breuer's hilarious stand-up about what happens in your stomach when you start drinking. Everything is fantastic until tequila shows up. That's definitively the party we are all participating in. US Treasury yields stabilize, providing more reasons for risky assets to rally. As investors take on more risk, the macro backdrop strengthens until yields resume again to rise. As 10-year yields hit 2%, the music stops, and everybody is out.
Thursday’s rally has just been a setback for US Treasuries before they resume their rise to 2%. What happened is that, finally, Japanese investors showed up to the party by increasing their overseas long-term bond investments. Japanese investors bought more overseas fixed income securities than last week, only 13 times since 2008. The move triggered a squeeze within short US Treasury bond futures positions, rushing speculators to close them, putting more pressure on the downward direction of yields.
Japanese investors’ convenience to buy into US Treasuries has been growing exponentially since the beginning of the year. Indeed, 10-year US Treasuries hedged with a 3-months forward against the Japanese yen offer a yield of roughly 1.22%, the highest since 2015. Yet, if one wants to hedge its FX exposure against JPY fully, their yield would fall to -0.21%. Only when US Treasury nominal yields hit 2% they would provide a yield equal to that of 10-year Japanese Government Bonds (JGB). That's why we believe that 2% in 10-year US Treasuries is a much stronger resistance level than 1.75%. Suppose the macroeconomic backdrop continues to strengthen, exacerbating inflation. In that case, the only way for 10-year US Treasury yields is to rise and try 2%. Until then, everything that is happening in the market is just noise.
(2) PBoC to hold rates steady as financial risk looms
We expect the PBoc to keep its Loan Prime Rate (LPR) unchanged at tomorrow’s interest rate decision. The focus will be again on balancing support to the economic growth and prevent financial risk. The latter is an increasingly important point amid the Huarong panic, which forced China's financial regulator on Friday to comment on the bad-debt manager financial conditions to put a stop to the rout. The central bank is also expected to expand stress testing to 4,024 banks this year, in contrast with 1,550 institutions tested in 2020. We see these actions as favourable to bond investors looking to take on Chinese credit risk. The PBoC is prioritizing financial stability by providing support and deleveraging the system.
Nevertheless, it's crucial bondholders remain cautious as corporate bond defaults are gaining momentum. This year, $16.7 billion of onshore and offshore debt has defaulted in only three months, which is already around half of the total corporate defaults of 2020 ($29.4 billion) and 2019 ($25.8 billion). Additionally, according to Bloomberg calculations, it has become more difficult for Chinese corporates to roll over debt.
(3) The European Central Bank cannot disappoint
On Thursday, the European Central Bank meeting will be in the spotlight as the central bank didn't deliver yet on the promise to control rising yields in the euro area. Strategists from the street are warning of “taper tantrum” risk within European sovereign bonds this week. They believe that if the ECB doesn’t sound dovish enough, yields will need to catch up with stronger economic expectations and faster vaccine roll-outs.
We share their view that there is no upside in holding European sovereigns currently. Nevertheless, we believe that the ECB will do its utmost to sound dovish at Thursday’s meeting because deflation risk remains the biggest concern in the euro area despite its improving macroeconomic backdrop. Let's compare the USD Inflation Swap Zero-Coupon rate curve with the EUR Inflation Swap Zero Coupon's one (chart below). We notice that inflation expectations in the euro area are entirely different from those in the US. The inverted Inflation Swap Zero-Coupon in the US tells us that inflation is due to a spike in the short term and normalize in the long term. In the case of Europe, inflation will slowly rise, yet missing the ECB target rate of 2%. Thus, the central bank must keep monetary conditions extremely accommodative to ensure that an economic recovery will revive inflation in the long term. Within this context, the ECB cannot tolerate a further rise of yields in the euro area because they have the potential to tighten financial conditions.
Last week alone, we have seen Portuguese 10-year government bond yields rising ten basis points to 0.42%. Although it isn't widely covered news, there is increasing concern that bad loan risk rises within Portugal's banking system. According to a recent interview, Fitch estimates that up to 10% of loans currently under moratoria could go bad as moratoria and other support schemes loosen up. At the same time. Last week Bank of Portugal's report shows that the ECB financing to Portuguese lenders rose in march to the highest since 2014. The Central Bank's financing of Portuguese banks peaked in June 2012 while the European sovereign crisis was unravelling and Portuguese 10-year government bonds were paying still well above 11% in yields. It adds to the rotation risk from European sovereigns to the US safe havens we have discussed in a previous analysis.
Economic Calendar:
Monday, April the 19th
Tuesday, April the 20th
Wednesday, April the 21st
Thursday, April the 22nd
Friday, April the 23rd
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