Risky assets become riskier as Treasury yields are near pivotal 1% level
Senior Fixed Income Strategist, Saxo Bank Group
Summary: The bond market is split: Treasury yields are rising together with risky assets. While there is plenty of evidence that the only way of interest rates is up, there is little support for lower-rated credits. As we are approaching the end of the year, it is crucial to reconsider risk within one's portfolio and cherry-pick corporate risk. In the short-term, the steepening of the real curve can provide an interesting upside.
Last week's rally in Treasuries which saw 10-year yields hitting 78bps was short-lived. However, it was enough to drive the volume of global aggregate negative-yielding debt at record high historical levels (Figure 1). As a Biden win looked likely, the U.S. yield curve started to steepen. Now 10-year yields are on their way up to 1%, and the pile of negative-yielding debt is declining once again. At this point of time, many are wondering whether there is a natural ceiling to the volume of negative-yielding debt, or whether higher rates present buying opportunity.
The market's narrative is clear: a Biden win together with an effective vaccine against Covid-19 will translate in substantial growth which ultimately will drive inflation and rates higher.
However, it's vital to understand that, at this point, the rise in yields is moved by growth expectations rather by inflation expectations. The Fed is letting rates rising in the hope that higher growth will lead to higher inflation. However, the central bank will not be able to wait on the sidelines for long as higher rates translate in lower spending as mortgage prices increase. In a vicious circle, lower spending ultimately may hinder inflation.In the chart below, we see that 10-year yields have been trading within a descending channel since the mid-'80s until today. In order to break their decennial descending trend, yields will need to test their upper trendline at 1.57%. It is at this level that we believe that the Fed will start to consider engaging in yield curve control.
Even though yield curve control remains a taboo, the market has started to behave as it may enforce one soon.
Yesterday, the Treasury was able to sell $41bn of 10-year Treasuries at 0.96% instead of 0.962% WI yield. It means that the demand for Treasuries continues to be supported even if their prices are falling. Interestingly, primary dealers’ award of these securities was higher than the previous auction as indirect bidder participation fell. Real money and foreign investors are often identified as indirect bidders. A drop in their demand matches the record high exposure we see in short bond future positions (Figure 3).
Yet, domestic investors are carefully listening to the Federal Reserve's speakers who highlight the importance to commit “to a path of policy and lowering borrowing costs along the yield curve” in order to achieve employment and inflation as Lael Brainard said on October 21st. Thus, some are locking in yields now as there might be more upside for Treasuries as the Fed will need to consider its next move.
Risky assets become riskier and more expensive
The corporate bond space doesn't seem to be biting to the higher rates narrative neither. Indeed since Biden won the election and a vaccine emerged, prices of high yields bonds rose incredibly fast. It means that even though rates are rising, investors listen to the frequent message coming from Federal Reserve speakers that yields will remain low for longer.
If rates rise too fast, they can pose a severe threat to the corporate world as higher rates increase funding risk for lower-rated corporates. If inflation increases as well, only companies that have the capability and flexibility to transfer rising costs directly to customers will be able to navigate the market, while others will be inevitably pushed out of business. It, therefore, makes sense to see investors such as Bill Ackman, founder of Pershing Square to bet against corporate credits.
We believe that at this point in time, it is crucial to assess risk carefully because rates are inevitably poised to rise, and it is just a matter of time until we see inflation picking up too. In the short-term, there are plenty of opportunities to take exposure to the steepening of the yield curve. In the long-term, it is necessary to revisit risky assets and cherry-pick corporate risk.
How can I gain exposure to a U.S. steepener on the Saxo Platform?
- Lyxor US Steepening 2-10 UCITS ETFs (STPU:xmil): at the time of writing the spread between the 2- and 10-year Treasury yields is around 80bps. If we expect 10-year yields to rise to 1.57%, and 2-year yields stay at the current level because of the yield curve control, therefore, will see spread to rise to 137.
- Short 10-year Treasury through CFD (10YUSTNOTEDEC2020) and Bond Futures (ZNZ0 for the December contract)
Which ETFs and CFDs give me exposure to riskier credits?
- iShares iBoxx USD High Yield Corporate Bond fund (HYG)
- High Yield ETF (HYLD)
- iShares USD High Yield Corporate Bond UCITS (IHYU)
- SPDR Bloomberg Barclays Cap. High yield Bond ETF (JNK)
- BlackRock Corporate High Yield Fund (HYT)
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