Fire and fury: a bond market response

Mid-Week Bond Update

Fire and fury: a bond market response

Global government bonds rallied after US president Trump threatened North Korea - a market response that was as fiery and furious as the military action threatened to be. The US 10-year Treasury yield fell to 2.22%, after finishing July at 2.29%. The presidential comments reversed a...

previous risk-on market mode, which was mostly triggered by a strong US jobs report on Friday and by an improvement in second-quarter corporate earnings. Leading equity indices, which reached new record highs earlier this week, turned. The heightened geopolitical tension stemmed the US dollar surge that followed Friday’s improved economic data. Still, the greenback gained against most major currencies over the past five trading days, except against the Japanese yen, which tends to rise in risk-off markets. The British pound fared worst, down 1.6% against the dollar, after the Bank of England cut the country’s growth forecast and a report showed that consumer spending dropped at an annualised rate of 0.8% in July. Bank of England governor Mark Carney warned last week that Britain’s planned departure from the European Union is weighing on companies and households.

Emerging Markets (EMs) were one of the few fixed income asset class survivors, especially dollar-denominated sovereign debt, up 0.6% over the past five trading days. Brazilian and Russian spreads over US Treasuries narrowed, helped by relatively stable oil prices but also because of improving fundamentals: in Russia, annualised inflation dropped to 3.9% in July, the lowest since 2012. EMs were also supported by generally positive data from China, which has been able to contain capital outflows on the back of a stronger currency (see below) and credit controls.



Emerging Markets – not another 2013: Both EM dollar and local currency-denominated sovereign bonds continued to add to returns over the past five trading days, resilient to the spiralling crisis in Venezuela – which would have generally hit the entire asset class a few years ago. This resilience signals improved investor confidence in countries such as Russia, Mexico, Poland or Brazil, which have introduced reforms and fought inflation over the past few years, with success. Some investors, however, are concerned that EMs could suffer once the US Federal Reserve (Fed) starts shrinking its balance sheet after years of buying financial assets in order to provide monetary stimulus. Western Asset’s portfolio manager and research analyst John Bellows, however, says that EMs are not likely to have the same negative reaction that they had in 2013, when the Fed first announced plans to curtain its stimulus – an episode known as Taper Tantrum. As shown on the chart, EMs currencies are now lower than in 2013, while spreads are higher – giving the asset class a crucially different starting point when the new tapering process starts. Please click here to read John Bellows’ “Four lessons from the Taper Tantrum of 2013.”


Dodging a Taper Tantrum: lower currencies, higher spreads may help

Source: Bloomberg 9 August 2017. The bar indicates the moment in which Taper Tantrum occurred. EM is Emerging Markets; EMBI is EM Bond Index. RHS is right hand side; bps is basis points. Past performance is no guarantee of future results. Please find definitions in the disclaimer.


Renminbi – look who’s rising: The Chinese currency was the top performing currency against the US dollar over the past five trading days, up 0.65%, taking its year-to-date gain to 4%. The currency reversed a weakening streak just as the turn of the year and following comments from the then newly elected president Trump, who claimed China was fuelling its growth thanks to a weak currency, which boosted exports. The renminbi, however, has strengthened over the past few months – a move that has helped the country stem a recent capital flight. Tighter controls in the credit market have also helped investors’ perceptions about the health of the country’s financial system.



US Investment Grade – High Yield – frenemies: The highest-rated US corporate bonds had a dismal five-day period, down by 0.4%, dragged down by a risk-off mode and a subsequent safe-haven rush. The asset class, however, is still up 1% over the past 30-day period, on the back of an improving domestic economy and higher second-quarter corporate profits. Such optimism usually makes Investment Grade corporate bonds more highly correlated to High Yield – something which is not always a good thing. As seen on the chart, it is in times of trouble when the correlation between two asset classes drops. On the other hand, it is in higher growth (or growth expectation) times that the two become more correlated – as it happened in the second half of 2016. The correlation started to fade earlier this year, as hopes of a quick improvement in the US economy started to wane. Recent improved data, however, had turned the correlation upwards again, but this means that the asset class got hit more in times of uncertainty or heightened geopolitical tension – like this week. Frenemies.


Investment Grade and High Yield: Frenemy behaviour

Source: Bloomberg as of 9 August 2017. Past performance is no guarantee of future results. Please find definitions in the disclaimer.


South Africa – not a political gem: The rand weakened over the past three days after South Africa’s president Zuma narrowly survived a no-confidence motion in parliament. The result doesn’t ease concerns about political risk in the country, which could further challenge its already ailing economy. Manufacturing production is falling and the Purchasing Managers’ Index (PMI) has fallen below 50, typically a sign of contraction. South Africa, the world’s largest platinum producer, is also vulnerable to volatile commodity markets and demand from China, one of its key trading partners.


Source for all data: Bloomberg and Barclays Capital as of 9 August 2017, unless indicated.