Fixed income chart pack for February
Senior Fixed Income Strategist
Summary: As interest rate hikes expectations advance globally, we see government bond yields soaring and yield curves bear-flattening. Risky assets do not show signs of distress yet, as real yields remain in deeply negative territory. The widening of corporate bond spreads is mainly attributable to rising interest rates, primarily affecting high-duration corporate bonds. However, as real yields rise towards 0%, we can also expect credit quality to become a problem. In the emerging market space, hard currency bonds are hard hit by rising yields in the US, while local currency debt remains supported as EM central banks tightened the economy already last year.
Amid market expectations of an aggressive Federal Reserve this year, ten-year US Treasury yields are heading towards 2%. Yet, the more aggressive the central bank is, the slower the future growth, compressing the rise of long-term yields. We expect an acceleration in long-term yields when the Fed provides further details concerning balance sheet policies.
Two-year US Treasury yields broke above 1.3% level. They are now in a new fast area where they could rise rapidly to test 1.40%. The front part of the yield curve will continue to rise as the market advances interest rate hikes.
As a consequence, the yield curve continues to bear flatten. The 5s30s spread fell below 50bps, and the 2s10s spread is finding strong support in the 60 area.
Balance sheet policies will need to come into play. To tighten the economy more efficiently, the Fed might consider combining rate hikes with its balance sheet runoff. That way, the Fed will avoid the yield curve to flatten further, and lift long-term rates. Because the long part of the yield curve is responsible for borrowing and mortgages costs, the central bank will be more effective at tightening the economy. At the same time, it might not need to hike rates as aggressively as the market is currently forecasting.
As central banks in Europe are getting aggressive, the market prices more interest rate hikes in the US. Now investors are expecting five interest rate hikes within the end of the year.
As interest rates rise in the euro area, US Treasuries’ appeal decreases for foreign investors. While at the end of January EUR hedged 10-year US Treasuries are paying more than 100bps over the German Bunds, now they pay 75bps. As the convenience to buy USTs lessens, bidding metrics at the US Treasury auctions might deteriorate.
The acceleration in real yields should begin to worry stocks and corporate bonds’ holders. Ten-year real yields rose more than 65bps since the beginning of the year. They broke above key resistance at -0.5%. As real yields get closer to 0%, the tighter the financing conditions, posing a threat for risky assets.
Thirty-year US Treasury real yields broke above 0% for the first time since May last year.
Bond Futures (Courtesy of Kim Cramer).
US 10 year T-Note broke bearish out of symmetrical triangle corrective pattern dropping to test support at 126 22/32. Next support at 125
Euro Bunds. After breaking below support at €167.70 next support is at around € 163.92 which is likely to be tested. Bollinger bands are expanding and RSI is below 40 threshold confirming the negative scenario.
Ten-year Bund yields broke above 0% and continue their rise as the ECB tilts hawkish. They will find weak resistance at 0.2%, 0.3% and 0.45% before finding strong resistance at 0.5%. Their tight correlation with US Treasuries and less accommodative policies from the ECB makes their rise inevitable.
The recent ECB's hawkish tilt has provoked the German yield curve to flatten the most since the 2008 global financial crisis.
Rising Bund yields and a less accommodative ECB spells troubles for European sovereigns with a high Beta, such as Italian BTPS. The BTP-Bund spread will continue to widen, and it has the potential to hinder the ECB tightening agenda. We expect political tensions to begin escalating as the BTPS-Bund spread breaks above 200bps, although the ECB will most likely not intervene to contain the widening until it breaks above 250bps.
Italian sovereign yields have risen exponentially with ten-year yields breaking resistance at 1.50%, entering in a fast area which could take them quickly to 2.15%. If they break above this level, they will find strong resistance next at 2.7%.
Yet, Greek government debt will suffer even more as the ECB pulls support away from the economy.
2013’s taper tantrum shows that an acceleration in real yields provoked the selloff in risky assets. Despite real rates remain in deep negative territory, their recent acceleration suggests that we might soon see weakness among lower-rated credits as real yields get closer to 0%.
Yet, the recent widening of corporate spreads is not attributable to credit quality deterioration. Indeed, duration has been the cause of much pain in the corporate space. Since the beginning of the year high quality credits, which also carry the highest duration has dropped nearly 5%, while CCC rated credits fell only by 2.3%. Of course things will change as volatility in rates markets remain elevated and financing conditions continue to tighten.
To prove the point that junk is yet not a problem, the spread between investment grade (IG) and high yield (HY) corporate remains below pre-pandemic levels.
Regardless, investors have begun to exit junk in January with the iShares iBoxx High Yield Corporate Bond ETF (HYG) suffering the worst exodus since September 2020. However, sentiment looks to have improved during the first week of February.
Hard currency emerging market debt is going to suffer this year as the Federal Reserve hikes interest rates. However, local currency debt will remain supported as the majority of EMs have already hiked rates last year. Therefore, EM’s central banks will not need to tighten their economies, supporting their country’s recovery. That’s why since the beginning of the year, local currency debt remained stable, while hard currency EM debt fell 4% in value.
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