And the winner is… China

Mid-Week Bond Update

And the winner is… China

US president Trump’s softer tone before Congress on Tuesday helped corporate bonds end a strong month for fixed income in general, buoyed by hopes of faster US growth and also by waning fears of a trade war with leading trading partners – mainly China. The general optimism was also...

...fuelled by strong data from the world’s No. 2 economy, whose health is highly correlated with US Treasury yields, more so than the strength of the US dollar, as seen in the chart below. The yuan, previously criticised by the new Administration for being kept purposefully low, moved slightly higher against the greenback. The improved global outlook, also based on stronger-than-expected growth in Australia and improved European manufacturing data, fuelled market implied expectations of a US interest rate hike in March: it doubled to more than 80%, up from 35% only last week. Credit spreads in both US Investment Grade and High Yield bonds tightened to levels not seen since 2014. The benchmark US 10-year Treasury yield jumped almost 7 basis points to 2.45% after some hawkish comments from Federal Reserve members.

Some Emerging Market (EM) currencies eased against a rising dollar, although they were still mostly up for the whole of February, and so far this year, lifted by improving fundamentals and rising commodity prices. EM hard currency spreads tightened. European sovereign debt gained, as political risk faded, mostly in France. The country’s risk premium over German bunds fell as anti-euro election candidate Le Pen saw her victory chances dwindle. Equity markets reached record highs. Some investors, however, remain cautious ahead of a month that is scheduled to bring key central bank meetings in Europe and the US, a national election in the Netherlands (with a leading anti-euro candidate) and, on the very last day, the trigger of the legislation that will start Britain’s exit from the European Union. All, before the French election in April and May, and the German one, later this year. Click here to read more about Western Asset’s optimistic, yet cautious, outlook.

 


ON THE RISE

Reflation trade – it’s not Trump, it’s China: Despite increased international fears of a hard-landing, extensive capital outflows, and a soaring debt burden, China posted above-expectations February manufacturing data on the back of rising producer prices. The good news helped the yuan hold its relatively stable streak against the greenback so far this year. The currency, which had been losing ground against the dollar since the devaluation of mid-2015, is now more underpinned by domestic fundamentals: import growth soared 17% in January, a pace not seen since 2013, surely welcome news for the Emerging Markets that export iron, copper or any other commodity to the country. As seen in the chart, it is this increased appetite for imports that is closely linked to US Treasury yields, which tend to rise on higher global growth hopes – symbolised by China imports. Other data, such as the increase in the cost of shipping containers from China, also from last year, support the view that it is this pick up in Chinese data that started the global reflation trade early last year. Some investors wonder, however, how sustainable it is.

 

Chinese imports: the heart of the reflation trade?

Source: Bloomberg as of 28 Feb. 2017. All data has been rebased to 100. USD is US dollar; S&P 500 is the Standard & Poor’s 500 Index; UST is US Treasury; yr is year. Please find definitions in the disclaimer.

 

Fallen angels – Rising: Companies that have been recently downgraded into a non-investment grade rating gained 0.5% over the past 5 trading days, taking their 12-month gain to 29% - the second-best performance among 33 fixed income asset classes, following EM inflation-linked bonds. The rally has been driven by the Energy and Metals and Mining sectors, which are recovering as energy prices have also traced back: oil, for instance, has risen to the current US$54 per barrel, from $26 barely one year ago. The Fallen Angels have expanded as an asset class, accounting now for about 22% of the High Yield universe, up from 8% in 1999, according to Brandywine Global. Click here to read why Brandywine Global believes that the Fallen Angels’ sometimes tarnished reputation may be undeserved.

 

ON THE SLIDE

French politicians: ne regrette rien: The charging of French election candidate Fillon for alleged misuse of public funds, and last week’s withdrawal of another rival to team up with poll leader Macron, have now strengthened the candidacy of the latter, a centrist. Although Fillon said his regrets wouldn’t stop him from fighting for the Elysée, his demise helped lift Macron’s chances to 51% and, most importantly, reduce those of anti-euro candidate Le Pen to 34%. This led to a relief rally in the country’s risk premium, with the spread between French and German sovereign bonds narrowing to 63 basis points, after reaching almost 80 last week. Other European sovereign bonds sighed in relief – Italian and Spanish spreads against bunds also fell, after reaching European sovereign crisis-heights last week.

 

French premium falls as anti-euro winds ease

Source: Bloomberg as 1 March 2017. The spread used is between German and French 10 year sovereign yields. RHS is right hand side. Please find definitions in the disclaimer.

 

Retail High Yield – not on/in line: In June last year, investors demanded the same risk premium to hold US High Yield (HY) retailers than the general HY index: 615 basis points (bps). They are now 190 bps apart – with HY retailers trading at 553 bps over Treasuries, well above the general sector’s 363 bps. Retail has missed HY’s recent rally, held by high leverage and changing consumer patterns – mainly an increased preference for online shopping. US High Yield as a whole, however, has continued to outperform this year, boosted by hopes of stronger growth. Click here to read which HY sectors could offer opportunity, according to Ken Leech, Chief Investment Officer of Western Asset.

 

Source for all data: Bloomberg and Barclays Capital as of 1 March 2017

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