Year in Review: Stability, sell-offs, and the slowdown

Year in Review: Stability, sell-offs, and the slowdown

Bonds 8 minutes to read
Althea Spinozzi

Head of Fixed Income Strategy

Summary:  The economy is turning, the late cycle is coming to an end, and the big remaining question will be what options central banks can deploy should sentiment turn more negative into 2019.


The end of this year leaves us with a great many questions. Is the selloff that we are seeing only the beginning? Are emerging markets out of the woods? Is the slowdown in growth going to continue in 2019? Will the conflict between China and US resolve itself? What about political instability in Europe?

These are the questions whose answers will determine portfolio performance in 2019.

While we cannot predict exactly how things will turn out next year, we can make an educated guess by looking at two key things: central bank policy and credit spread directionality.

Hawkish Powell to turn dovish in 2019

We started 2018 with a new Federal Reserve chair, and since his first speech the market understood that the path ahead was one of interest rates hikes and disinvestment. Jerome Powell has kept his word, and what we have seen throughout the whole year was a hawkish Fed concerned by overshooting inflation and economic expansion.

Things, however, have recently taken a turn and amid a sell-off in the equity market and a slowdown in global economic growth, investors speculate that the hawkish approach of the Fed will end with markets expecting only a single hike in 2019.

Speculation on a dovish Fed has been enough to push the 10-year US Treasury yield back below the 3% level, which marked a local high after eight years of sub-3% yields. This caused a further flattening of the yield curve and an inversion in the short part of the curve between two- and five-year maturities.

Our expectations regarding US monetary policy depend on economic performance. The central bank’s continued data-dependence was made abundantly clear at the December 19 Fed meeting where Powell responded to questions about falling equity prices by referring to economic growth and unemployment numbers. This means that that until the Fed sees a slowdown in US economic data, forward guidance will remain hawkish – unfortunately causing more panic among investors.

On the other hand, if the trade war headlines don’t relent and the market continues to fall, we can expect Powell to slow his policy normalisation roll.

We believe that an inversion of the yield curve is inevitable no matter what the Fed does or doesn’t do. If short-term interest rates rise because the economy is growing, we can expect the short part of the curve to rise faster than the long; conversely, if the Fed slows its rate hikes due to trade at equity market turmoil, we can expect the longer part of the curve to fall faster than the short one.

Europe playing a cautious hand

In Europe, things have gone in a different direction. The year started relatively well, with European Central Bank president Draghi promising to stop asset purchases under the QE programme and to begin hiking interest rates, but political risks within the European Union have been too severe to allow such a course of action.

While Brexit has been priced into the market since the vote in 2016, volatility started to rise amid the Italian elections in May and recently peaked amid news regarding the Gilets Jaunes movement in France, as well as Angela Merkel’s resignation as CDU leader in Germany and the continuous rise of populist parties in Spain.

After Draghi’s speech on December 13, it became clear that the ECB is playing its cards cautiously; the only thing that can do to aid the economy and stabilise the market is to keep its enormous balance sheet invested for longer. Although the ECB wraps up asset purchases this month, it has made it clear it that will keep interest rates low for as long as is needed (although it has specified that it won’t hike until summer 2019, but investors speculate that it will not do so until 2020) and that reinvestment of principal maturities will be reinvested beyond rate hikes.

This means that bond valuations in the euro area will be supported throughout 2019, and this represent a buy opportunity for many of those credits that have widened amid recent volatility.

Storm clouds facing high-yield bonds and leveraged loans

As you can see from the graph below, both European and US high yield credit spreads have been widening over the past couple of years. This has been due to various factors including as risk-off sentiment among investors, which has pushed them to dump risky assets purchases while rates were at record lows.

Rising interest rates in the US have not only caused the cost of funding to rise, they have also pushed investors to realise that their risky assets could become extremely volatile if the economy turned. Additionally, with interest rates rising it has started to be easier for investors to find quality assets with interesting returns.

In Europe, high-yield spreads have been widening faster than in the US despite rates holding steady. This has mainly been due to political instability in various European countries, including Brexit.

Assuming a stabilising trend into next year, the ECB’s continued support of the European recovery could leave selective high-yield European credits ripe for allocation.

With the high-yield space slowing down, and large amounts of leverage debt in the system, we expect high-yield bonds to continue to suffer. In our view, the investment grade space offers more opportunity.

US & EU high-yield
This past year was many things, but it wasn’t boring. We have seen the market move in ways that just a few short years ago would have seemed impossible, and this is paving the way towards an interesting 2019.

The economy is turning and the late cycle is coming to an end. As we head into the New Year, it’s not hard to envisage a situation in which sentiment and circumstances turn more negative still, with central banks having fewer cards to play than they once did.

Quarterly Outlook

01 /

  • Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges

    Quarterly Outlook

    Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges

    Althea Spinozzi

    Head of Fixed Income Strategy

  • Equity Outlook: Will lower rates lift all boats in equities?

    Quarterly Outlook

    Equity Outlook: Will lower rates lift all boats in equities?

    Peter Garnry

    Chief Investment Strategist

    After a period of historically high equity index concentration driven by the 'Magnificent Seven' sto...
  • FX Outlook: USD in limbo amid political and policy jitters

    Quarterly Outlook

    FX Outlook: USD in limbo amid political and policy jitters

    Charu Chanana

    Chief Investment Strategist

    As we enter the final quarter of 2024, currency markets are set for heightened turbulence due to US ...
  • Macro Outlook: The US rate cut cycle has begun

    Quarterly Outlook

    Macro Outlook: The US rate cut cycle has begun

    Peter Garnry

    Chief Investment Strategist

    The Fed started the US rate cut cycle in Q3 and in this macro outlook we will explore how the rate c...
  • Commodity Outlook: Gold and silver continue to shine bright

    Quarterly Outlook

    Commodity Outlook: Gold and silver continue to shine bright

    Ole Hansen

    Head of Commodity Strategy

  • FX: Risk-on currencies to surge against havens

    Quarterly Outlook

    FX: Risk-on currencies to surge against havens

    Charu Chanana

    Chief Investment Strategist

    Explore the outlook for USD, AUD, NZD, and EM carry trades as risk-on currencies are set to outperfo...
  • Equities: Are we blowing bubbles again

    Quarterly Outlook

    Equities: Are we blowing bubbles again

    Peter Garnry

    Chief Investment Strategist

    Explore key trends and opportunities in European equities and electrification theme as market dynami...
  • Macro: Sandcastle economics

    Quarterly Outlook

    Macro: Sandcastle economics

    Peter Garnry

    Chief Investment Strategist

    Explore the "two-lane economy," European equities, energy commodities, and the impact of US fiscal p...
  • Bonds: What to do until inflation stabilises

    Quarterly Outlook

    Bonds: What to do until inflation stabilises

    Althea Spinozzi

    Head of Fixed Income Strategy

    Discover strategies for managing bonds as US and European yields remain rangebound due to uncertain ...
  • Commodities: Energy and grains in focus as metals pause

    Quarterly Outlook

    Commodities: Energy and grains in focus as metals pause

    Ole Hansen

    Head of Commodity Strategy

    Energy and grains to shine as metals pause. Discover key trends and market drivers for commodities i...
Disclaimer

The Saxo Group entities each provide execution-only service and access to Analysis permitting a person to view and/or use content available on or via the website is not intended to and does not change or expand on this. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Saxo News & Research and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Group by which access to Saxo News & Research is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Saxo News & Research or as a result of the use of the Saxo News & Research. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. Saxo News & Research does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws.

Please read our disclaimers:
- Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)
- Full disclaimer (https://www.home.saxo/en-hk/legal/disclaimer/saxo-disclaimer)

None of the information contained here constitutes an offer to purchase or sell a financial instrument, or to make any investments. Saxo does not take into account your personal investment objectives or financial situation and makes no representation and assumes no liability as to the accuracy or completeness of the information nor for any loss arising from any investment made in reliance of this presentation. Any opinions made are subject to change and may be personal to the author. These may not necessarily reflect the opinion of Saxo or its affiliates.

Saxo Capital Markets HK Limited
19th Floor
Shanghai Commercial Bank Tower
12 Queen’s Road Central
Hong Kong

Contact Saxo

Select region

Hong Kong S.A.R
Hong Kong S.A.R

Saxo Capital Markets HK Limited (“Saxo”) is a company authorised and regulated by the Securities and Futures Commission of Hong Kong. Saxo holds a Type 1 Regulated Activity (Dealing in Securities); Type 2 Regulated Activity (Dealing in Futures Contract); Type 3 Regulated Activity (Leveraged Foreign Exchange Trading); Type 4 Regulated Activity (Advising on Securities) and Type 9 Regulated Activity (Asset Management) licenses (CE No. AVD061). Registered address: 19th Floor, Shanghai Commercial Bank Tower, 12 Queen’s Road Central, Hong Kong.

Trading in financial instruments carries various risks, and is not suitable for all investors. Please seek expert advice, and always ensure that you fully understand these risks before trading. Trading in leveraged products may result in your losses exceeding your initial deposits. Saxo does not provide financial advice, any information available on this website is ‘general’ in nature and for informational purposes only. Saxo does not take into account an individual’s needs, objectives or financial situation. Please click here to view the relevant risk disclosure statements.

The Saxo trading platform has received numerous awards and recognition. For details of these awards and information on awards visit www.home.saxo/en-hk/about-us/awards.

The information or the products and services referred to on this site may be accessed worldwide, however is only intended for distribution to and use by recipients located in countries where such use does not constitute a violation of applicable legislation or regulations. Products and services offered on this website are not directed at, or intended for distribution to or use by, any person or entity residing in the United States and Japan. Please click here to view our full disclaimer.

Apple, iPad and iPhone are trademarks of Apple Inc., registered in the US and other countries. AppStore is a service mark of Apple Inc. Android is a trademark of Google Inc.