A widely-anticipated US Federal Reserve (Fed) rate hike accompanied by central bank reassurance about the present accommodative stance reversed a negative streak for...
global bond markets, which had fallen on the higher rate expectations and falling oil prices. The Fed hiked rates by one quarter point to 1% but left its forecast of 2 more hikes this year intact. This ignited a rally in US sovereign and corporate bonds, as well as a surge in commdity prices and Emerging Market (EM) currencies - the South African rand rallied 2.9% percent the US dollar, and the Mexican peso, 2.3%. A softer dollar is a relief for the many EMs that have dollar-denominated debt. US inflation expectations rose and gold, often seen as a hedge against rising prices, added 1.9%. The general upswing came as financial assets have traditionally done well in this scenario: rising rates signal a strengthening economy - but not strong enough to end the present monetary easing. What did Legg Mason portfolio managers say after the Fed move?
The global outlook continued to improve: US job growth was strong in February; European Central Bank president Mario Draghi practically proclaimed victory over deflation and China’s industrial production, retail sales and capital investment all jumped, softening investors’ concerns about a potential hard-landing in the world’s second-largest economy. Before the Fed announcement, the only asset classes that had posted slight gains over the past five trading days, among a group of 33 analysed, were UK inflation-linked bonds, Emerging Market (EM) local debt and US non-agency mortgages, whose floating rates could benefit in a rate-rising cycle.
ON THE RISE
European politics – Dutch kick-start: The Netherlands held on Wednesday the first of the three European national elections pending this year: the French will vote on April 23 and May 27, and the Germans, on Sept. 24. The Dutch vote is widely seen a test of the real drive of populism in Europe, following the success of non-conventional, anti-establishment candidacies in the US and Britain last year. In the Netherlands, the anti-elite leader is the far-right, anti-euro PVV party, which was very far from any majority, according to the polls, on election day. Despite some observers’ belief that the more socially-protective continental Europe would be less keen on anti-globalisation and anti-status-quo proposals, political uncertainty risk has increased in the old continent. Regardless of Europe’s incipient recovery after almost a decade of stagnation, European investment-grade corporate spreads have practically caught up with their US counterparts, something that has only happened in times of stress, such as during the European sovereign debt crisis, as seen in the chart. The European political ball has been rolled. Click here to read Brandywine Global's view on the forthcoming French election, and here for a Legg Mason guide to this year’s votes.
Signs of trouble?
European spreads near their US counterparts in delicate times
Source: Bloomberg as of 15 March 2017. The indices used are the Bloomberg Barclays US Aggregate Corporate Average OAS (Option Adjusted Spread) and Bloomberg Barclays Euro Aggregate Corporate Average OAS . Please find definitions in the disclaimer.
EM flows – flowing: EM fund flows have been positive for ten consecutive weeks, with bond flows outpacing equity ones this month. Although the bulk of fixed income EM inflows go into hard currency-denominated assets, the local government bond asset class has more than doubled in size over the past decade to the present US$ 1.8 tn, according to Barclays Capital data. Local currency denominated EM sovereign bonds were one of the few fixed income asset classes to post gains over the past five trading days, taking their 12-month performance to 7.6%, and its 3-year one to 24%. Also when measured in local currency terms, the asset class has more than recovered from the slump it suffered following the US election in November, on fears that president Trump’s future trade policies could hit EM exports and hinder global trade. These concerns seem to have abated now, with investors focusing more on the improving fundamentals of countries such as Mexico, Russia, India, Indonesia and the Philippines.
ON THE SLIDE
Friends of US Treasuries - beware: US government bonds should be especially sensitive to the Fed’s commitment to bring back interest rates up to levels more in tune with the heartbeat of the economy – a process known as normalisation. Initially, this may not be good news for short-maturity US Treasuries, as bond prices fall when rates rise, and US government bonds don’t pay the high coupons seen in other asset classes, such as High Yield, that can cushion the effects of a price drop. This means some investors are closely monitoring which asset classes move in tandem with Treasuries, and which ones tend to rise when Treasuries fall. As seen in the chart, a falling Treasury market has been positive, over the past 2 years, for the Japanese yen, US equities, High Yield assets and loans – as some have floating rates that may rise when interest rates go up. On the contrary, falling Treasuries have been bad news for US and European investment-grade corporate bonds and European sovereigns. EM local sovereign bonds have been barely correlated to Treasuries over the same period – good news for active managers who see asset fundamentals are their no. 1 criteria.
Together we rise… and fall
Correlation with US Treasuries (2 years)
Source: Bloomberg as 15 March 2017. Inf. Exp is inflation expectations; HY is High Yield; GBP is British pound, USD is US dollar; EM loc (unh) is Emerging Markets local (unhedged); corp is corporate; sov is sovereign. Please find definitions in the disclaimer.
US 10 – 30 curve – less optimistic? For all the surges in market-implied expectations of future rate hikes ahead, there is one sector in the bond market that doesn’t see such a rosy picture ahead: the difference between 10 and 30-year US Treasury yields has fallen to 57 basis points, near its two-year low (reached in December). This means that while 30 year yields have increased, they haven’t risen as much as 10 year ones, a sign that investors don’t have much faith in fast-paced accelerating growth or inflation in the long term. Some investors attribute this to structural issues, such as low productivity, ageing population or not enough wage pressure. Some investors, such as Western Asset, also say that shorter-term challenges, such as a still fledgling global economy, are far from having disappeared. Click here to read the latest market commentary from Ken Leech, Chief Investment Officer of Western Asset.
Source for all data: Bloomberg and Barclays Capital as of 15 March 2017, unless indicated.