Macro: Sandcastle economics
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Weekly Bond Update: No season to cheer
Althea Spinozzi
Head of Fixed Income Strategy
Summary: An increasingly hazardous cocktail of political and economic uncertainty means that investors cannot just sit back and relax this Christmas – from here on, vigilance is essential.
Investors are in for an unpleasant surprise this year. Instead of the usual seasonal cheer and the merrymaking of Christmas, they must brace for precarious market conditions and a political and economic landscape under siege from uncertainty and instability. The equity market has been particularly volatile since the end of the summer and most worryingly, the debt market is starting to show serious signs of distress that are heaping more and more pressure onto already fragile financial markets.
Trade war headlines, uncertainty regarding central bank policies and political tension in Europe have contributed to wider credit spreads of high yield corporates both in Europe and in the United States. As you can see from the figure below, HY credits have been widening the fastest since the beginning of October until now. And in this case, rates have little to do with it. As a matter of fact, US sovereign yields have been falling at the long end of the curve, while at the short end, rates have been range bound, though this did not help credit much.
We can therefore confidently say that cost of funding has increased 50%, reflecting both negative investor sentiment and a degradation of credit, which slowly progressed in the past few years due to the large M&A activities and easy issuance of HY bonds and leveraged loans.
Trade war headlines, uncertainty regarding central bank policies and political tension in Europe have contributed to wider credit spreads of high yield corporates both in Europe and in the United States. As you can see from the figure below, HY credits have been widening the fastest since the beginning of October until now. And in this case, rates have little to do with it. As a matter of fact, US sovereign yields have been falling at the long end of the curve, while at the short end, rates have been range bound, though this did not help credit much.
We can therefore confidently say that cost of funding has increased 50%, reflecting both negative investor sentiment and a degradation of credit, which slowly progressed in the past few years due to the large M&A activities and easy issuance of HY bonds and leveraged loans.
Unfortunately, bad news rarely comes alone, and it seems that real money is also getting cold feet. According to data published by Japan’s ministry of finance, Japanese real money investors have been selling German, French and US sovereign bonds (Figure 2).
While it is normal for real money to adjust investments according to interest rates predictions, and for this reason we have seen Japanese outward investment leaving US Treasuries in February when Jerome Powell became Federal Reserve chairman and subsequently struck a particularly hawkish tone, what it is not normal is for real money to take a speculative stance amid intense market volatility and political uncertainty.
This is actually what we have seen in the month of October: Japanese real money selling German, French and US bonds, but buying the Italian ones which as we already know, have been rather a roller-coaster ride of late.
While it is normal for real money to adjust investments according to interest rates predictions, and for this reason we have seen Japanese outward investment leaving US Treasuries in February when Jerome Powell became Federal Reserve chairman and subsequently struck a particularly hawkish tone, what it is not normal is for real money to take a speculative stance amid intense market volatility and political uncertainty.
This is actually what we have seen in the month of October: Japanese real money selling German, French and US bonds, but buying the Italian ones which as we already know, have been rather a roller-coaster ride of late.
This should send a strong message to investors: that amid high volatility and uncertainty it is not possible any more to buy and hold either equity or fixed income securities. Relative value and opportunistic trades become the norm du jour even for the most conservative investors. In order to be successful in positioning it is therefore important to understand where risks and opportunities lie.
Treasuries: Risk and opportunities
While the trade war remains in the headlines and is one of the most important risk factors in the US, it is not the main driver of Treasuries’ performance. What is driving performance at this point is clearly the path of rate hike expectations. This is why for investors the analysis of macroeconomic data has become paramount in order to understand whether economic indicators will underpin more hikes. And at this point with global economy slowing down, and CPI remaining under control, the Fed might take a more dovish approach.
Unfortunately, opportunities in the US yield curve are limited while risks are high. Indeed, the long part of the curve has been compressing on the back of trade war concerns and market belief that Powell will not hike in 2019, however Treasury bond issuance remains high and if headlines of a trade war and concerns about a slowing economy disappear, and the Fed continues to hike interest rates, the US yield curve would shift upwards, resulting in losses for bond holders all across the yield curve. Of course, this seems an unlikely scenario at the moment, however it is for this reason that we prefer to look at short-duration USD-denominated corporate bonds, which normally suffer less from interest rate shifts than do longer maturities.
Europe: not clear what the direction is
More complicated is the situation in Europe, where political tensions are mounting, pointing to the fact that many of the European sovereigns are overpriced. Among the most worrying factors are:
Brexit: whatever deal that can be done is better than a no-deal, and everybody knows it. Gilts have been rallying in the past few months as investors flew to safety, however, many are conscious of the fact that as soon as any deal is reached the downside in sovereigns might be big, and from a yield of 1.20% for the 10-year gilts, they could quickly reach 2%.
New CDU leader Germany: although many sighed in relief as Annagret Kramp-Karrenbauer was elected as leader of the CDU, everybody knows that it will be very hard to keep the grand coalition with the CSU and the SPD together. German Bunds are trading with a yield of 0.25% and it is clear that the upside it limited.
French deficit rises: Since President Emmanuel Macron announced concessions to the gilets jaunes, it is clear that the French deficit will rise above the level permitted by the European Union. When Macron's concessions became known, the spread between the France 10-year OAT and 10-year bunds rose to a new high of 45bps. We may see the spread widening further as tension with the EU mounts.
Italian politicians might reconsider deficit target for 2019: The real question is: will they, now that France is breaching European fiscal rules? We will know pretty soon but in the meantime a spread of 280bps between Italian BTPs and bunds is compelling, especially when we look at the corporate space where we’ll see that there are not many HY corporate bonds offering the same.
Treasuries: Risk and opportunities
While the trade war remains in the headlines and is one of the most important risk factors in the US, it is not the main driver of Treasuries’ performance. What is driving performance at this point is clearly the path of rate hike expectations. This is why for investors the analysis of macroeconomic data has become paramount in order to understand whether economic indicators will underpin more hikes. And at this point with global economy slowing down, and CPI remaining under control, the Fed might take a more dovish approach.
Unfortunately, opportunities in the US yield curve are limited while risks are high. Indeed, the long part of the curve has been compressing on the back of trade war concerns and market belief that Powell will not hike in 2019, however Treasury bond issuance remains high and if headlines of a trade war and concerns about a slowing economy disappear, and the Fed continues to hike interest rates, the US yield curve would shift upwards, resulting in losses for bond holders all across the yield curve. Of course, this seems an unlikely scenario at the moment, however it is for this reason that we prefer to look at short-duration USD-denominated corporate bonds, which normally suffer less from interest rate shifts than do longer maturities.
Europe: not clear what the direction is
More complicated is the situation in Europe, where political tensions are mounting, pointing to the fact that many of the European sovereigns are overpriced. Among the most worrying factors are:
Brexit: whatever deal that can be done is better than a no-deal, and everybody knows it. Gilts have been rallying in the past few months as investors flew to safety, however, many are conscious of the fact that as soon as any deal is reached the downside in sovereigns might be big, and from a yield of 1.20% for the 10-year gilts, they could quickly reach 2%.
New CDU leader Germany: although many sighed in relief as Annagret Kramp-Karrenbauer was elected as leader of the CDU, everybody knows that it will be very hard to keep the grand coalition with the CSU and the SPD together. German Bunds are trading with a yield of 0.25% and it is clear that the upside it limited.
French deficit rises: Since President Emmanuel Macron announced concessions to the gilets jaunes, it is clear that the French deficit will rise above the level permitted by the European Union. When Macron's concessions became known, the spread between the France 10-year OAT and 10-year bunds rose to a new high of 45bps. We may see the spread widening further as tension with the EU mounts.
Italian politicians might reconsider deficit target for 2019: The real question is: will they, now that France is breaching European fiscal rules? We will know pretty soon but in the meantime a spread of 280bps between Italian BTPs and bunds is compelling, especially when we look at the corporate space where we’ll see that there are not many HY corporate bonds offering the same.
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