The second quarter of 2018 has started at full speed. Volatility has again risen above 21% on a possible trade war between the US and China, and the market is not losing any time in repricing numerous assets. While equities fall, the bond market is slowly waking up from hibernation. Bonds seem as yet unable to see what the fuss is all about, but at this point it is important to ask ourselves whether the equity market sell-off is going to bleed into the fixed income world anytime soon.
Although US Treasuries have been sliding since the beginning of the year, the uncertainty and volatility that we have seen in the past few weeks have pushed yields back down, forcing 10-year Treasuries to close last week at 2.77% – a level far away from the psychological 3% level many have been waiting for.
The risk-off relationship between bonds and equities was restored last week as the market fled to safety. However, it is yet not clear how investors will price in the risks implied by trade war. This means that the rally we have seen in Treasuries may be a premature market reaction to uncertainty and the long-term direction might, in fact, be trending the opposite way.
There are three main reasons why Treasuries may go lower:
1) Monetary policy tightening. However we look at that, we can agree that the only option available to the Federal Reserve is to tighten monetary policy. The yield curve is the flattest it has been in 10 years, meaning that the spread between 10-and two-year Treasury yields is around 50 basis points, leaving the fed little room to manoeuvre. In order to avoid an inversion of the yield curve, which in the past has been a clear sign of recession, the Fed has to use all its available tools in order to gradually tighten monetary policy and slowly raise rates.
2) A decrease of the scarcity value in Treasuries. This marks the end of an era. Since the aftermath the financial crisis, we have become used to seeing Treasuries as a rare commodity as the Fed has been massively buying part of this debt, pushing Treasury yields downwards. Now that the Fed is ending its quantitative easing, and the US Treasury needs to issue more and more bonds in order to fund its fiscal deficit, we can safely assume that supply will be higher than demand.
3) Political instability. This might be premature, but many investors already believe that the erratic behaviour of President Trump is causing Treasuries to lose their safe-haven status. If this proves to be the case, many international reserve funds may need to revise their investment strategies and look beyond Treasury bonds. Already, only 42% of US Treasuries are held by foreigners – the lowest percentage since 2003. Is this because investors are aware that the tightening measures of the Fed imply that Treasuries will fall, or are investors slowly losing confidence in the US?
I personally believe that the above are good enough reasons to add pressure to Treasuries, but if we want more food for thought, we cannot forget that China is the largest holder of US government bonds after the Fed and if the rhetoric around a trade war escalates we can assume that this point would most likely be touched by Chinese counterparties.
It is important to consider trends in US government bonds because they normally suggest what is to come in the biggest part of the bond world. When Treasuries move, all USD-denominated bonds move and also bonds in other currencies are normally affected.
The big topic here is that if Treasuries are doomed to fall, we can expect weaker bonds to be put under increasing stress, leading to events that coukd serve as a catalyst for defaults and repricing in the broader asset class.
Although different in many ways, the recent fall in Russian corporate bonds can prove an important point: whenever valuations are too tight, the market becomes overly sensitive and ready to sell risk. In the Russian case, the catalyst has been the imposition of major sanctions against numerous Russian businessmen... but the alarm bells were ringing well before this news.
Indeed, one of the most discussed topics at the beginning of 2018 was Russian bonds’ massive rally in the last few years. Russia had become incredibly popular among emerging market investors as resilient oil prices and a positive economic outlook have contributed to solid returns. This led to a substantial tightening of credit spreads, which made Russian bonds look expensive compared to their peers in other emerging markets. Many Russian investors have recently been looking outside of Russia for investment opportunities as they thought that the risk-return relationship was not rewarding.
Another important point is that the sanctions have served as a catalyst also to reprice the corporate debt of companies such as Gazprom and Lukoil, which are not directly affected by them. This is happening because investors cannot find comfort in the unpredictability of the US government, as they fear that further headline risks are likely to follow.
As my colleague Ole Hansen once said, whenever there is a loser there is also a winner, and the sanctions on Russian companies are actually driving Russia’s aluminium business towards China – the very country that has been recently targeted harshly by Trump’s administration.
This raises questions on whether the US government knows what it is doing. And this brings us back to our initial thoughts about Treasuries.
As US credit continues to deteriorate while credit spreads remain stable, the market becomes more sensitive to headlines, making the current equilibrium almost impossible to maintain.