Head of Fixed Income Strategy
Summary: Treasuries weren't the only beneficiaries of the volatility spurred by the U.S. election. Surprisingly, risky assets have been rallying too. U.S. junk credit spreads have tightened significantly while investment-grade spreads are lagging. We believe that investors are buying higher-yielding assets because they expect more support from the Federal Reserve. The same is happening in Europe with Gilts and BTPs tightening considerably compared to peers as investors expect more support from their respective central banks.
Investors are convinced that the market has been trading the U.S. election this week; however, there are signs that central banks have been the real protagonists.
Indeed, while uncertainties around the U.S. election's results pushed Treasuries higher, risky assets didn't lose steam even amid the second wave of coronavirus infections. We, therefore, cannot say that the sudden rise in Treasuries was dictated by risk-off sentiment.
On Wednesday, as a Biden win seemed not as evident, the U.S. yield curve started to flatten with the 10-year Treasuries leading the gains. Yields fell fast across the curve pointing to the perfect risk-off scenario, except that the S&P 500 index was rising as well. The stock market was not alone in the rally; as a matter of facts, credit spreads also tightened considerably with higher-yielding credits leading the way.
In the graph below, we look at the one week change in CDS spreads for various credit sectors. Junk bonds have been leading the gains in credit with health, utilities and energy credits being the best performers. Investment-grade credit spreads have also tightened but modestly compared to high yield spreads.
The price movement in credits shows that even if there is not a clear winner yet, investors have decided to continue to rely upon central banks.
Central banks have been expanding their balance sheet dramatically from the global financial crisis until today. As the economic crisis inflicted by the Covid-19 pandemic intensifies, they will most likely not be able to stop printing money. The outcome will inevitably be near-zero benchmark rates for longer and bigger and bigger bond-buying programmes. They can even contemplate engaging in even more unconventional policies, considering to start to buy other instruments beyond bonds. The Federal Reserve, for example, is already buying ETFs, therefore expanding to stocks would not be that far fetched.
As a consequence, this week, investors decided to put their money at work in assets that will benefit the most from central bank policies. Because junk credit spreads trade rich compared to investment grade's bonds, with the unlimited support of the FED, these are also the assets with the most significant upside. Hence, this explains the rise in junk assets prices.
To strengthen this thesis is the behaviour of European sovereigns that we have seen on Wednesday as a Biden win seemed less likely. Gilts and Italian BTPs have led the rally, and the only explanation for this is that investors were buying the ECB and those assets that will benefit the most from more accommodative policies.
Buying the central bank might be a winning strategy in Europe still; however, it might be too late to buy the FED in the United States especially when talking about Treasuries. Even though the 10-year Breakeven rate has fallen this week supporting the Treasuries' rally, another economic shock coming from the Covid-19 will most likely exacerbate an uptick of inflation. On top of it, the next President of the U.S. regardless of whom will be will need to push through congress a stimulus package. Reflation in 2021 will be real, and near-zero interest rates will be the worst thing you might hold on. In the mid-term, however, there might be scope for more upside within higher-yielding credits, as the Federal Reserve expands its bond purchasing program and tries to save the economy.2024: The wasted year
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