From Davos with Growth

Mid-Week Bond Update

From Davos with Growth

Nothing like a few optimistic messages from Davos to give further fuel to world equities and to lift bond yields to levels not seen in four years. The proposed US tax cuts that continued to take US equities to yet another record also led the International Monetary Fund to lift its global economic outlook earlier...

this week, pushing the world benchmark US 10-year Treasury yield to 2.65%, the highest since 2014. Stable growth in China, rising oil inventories, positive European manufacturing data, as well as improving inflation in Mexico and Brazil all led to a cheerful mood in Davos, the alpine resort where the global elite gathers every January.

World leaders, however, also signalled some warnings, including comments about rich asset valuations and the potential for higher inflation and rates. No sooner had they spoken, oil surpassed US$ 65 per barrel for the first time since 2014, Canada hiked rates and Argentina disappointed some investors with an unexpected rate cut which sank the peso against a falling US dollar. The US currency dropped after US Treasury Secretary Mnuchin said in Davos that a weak dollar is good for trade (read more below). Away from the glitter of the Swiss resort, investors’ eyes focused on Thursday’s European Central Bank meeting and on the new round of talks of the North American Free Trade Agreement (NAFTA), which could significantly impact the US and Canadian dollars, as well as Mexico’s growth, currency and exports.

 

ON THE RISE

Emerging vs Developed market yields – the real difference: Emerging Markets (EMs) have rallied over the past one month period, fuelled by the stable growth of their leader, China, by a falling US dollar, and by their own improving fundamentals – especially on the inflation front: In Mexico, price growth plunged by the most in 20 years to an annualised 5.51%, while in Brazil, inflation accelerated less than expected in the month through mid-January, mostly driven by lower energy costs. Lower inflation has driven up EM real yields, which do not include any inflation premium, while developed market real yields have remained at negative levels, contained by rising inflation and still overall slow growth (see chart). The difference between the two is now at almost a decade high and could increase if EM inflation continues to improve. Click here to read why Western Asset’s Chief Investment Officer Ken Leech believes that EMs may continue to offer attractive investment opportunities this year.

 

Don't let inflation eat your yield: real yields show EM investors get more bang for the buck

Emerging Markets Yields

Source: Western Asset as of 24 January 2018. EM is emerging markets; DM is developed markets; RHS is right hand side; bps is basis point. Please see disclaimers for definitions.

 

British pound – in search of lost time: The British currency continued its upwards move towards the level it had in June 2016, when the country voted to leave the European Union (EU). Fears that the domestic economy would sink have largely waned, and this week’s improved jobs data helped ignite a 3% rally against the US dollar. The currency is now down only by almost 4% against the greenback since the EU referendum in June 2016, a sharp recovery from the 19% it had lost, after the referendum, now one year ago. Improved wage data also helped the rally, as did comments from Brexit Secretary David Davis, who assured lawmakers that the UK will stay closely aligned with EU regulation after it leaves. A transition agreement is now expected by March. Early green shoots?

 

ON THE SLIDE?

US dollar – message in Davos: Rising bond yields and a falling currency do not tend to come together, as higher yields usually attract foreign investors, increasing demand for the currency. But in January, we have seen the opposite in the world’s biggest bond market: while US Treasury yields have shot up, the currency has dropped, especially as US officials used the effective Davos platform to send the world a message: a weak dollar is good for trade, said Treasury Secretary Steve Mnuchin at the World Economic Forum. Indeed, and as seen on the chart, US exports (blue line) increased especially between 2003 and 2008 as the dollar plunged (orange line), a pattern that happened again after 2010 and, again, now. So far, the Trump Administration has been able to combine its pro-growth and pro-weak dollar messages, but how long can this last? Europe and EMs, whose currencies automatically rise as the dollar falls, are watching.

 

US Treasury Secretary hails weak dollar - this is why:

US Treasury Secretary Hails Weak Dollar

Source: Bloomberg as of 24 Jan. 2018. Please find definitions in the disclaimer.

 

Argentina – Malos Aires: The peso plunged 3.5% against the US dollar over the past five trading days - a cold sign sent by investors following the central bank’s surprise rate cut earlier this week. The 75 basis points (bps)-cut, to 27.25%, came right after another 75 bps cut only two weeks ago, and after two consecutive hikes as recently as October and November last year. The central bank said the present policy is too contractionary, hence the extra cut, but some investors believe this was unnecessary given the inflation pressures and the credibility hit that the move led to. Some investors also believe that controlling inflation should be more a matter of prudent fiscal policy, the structure of fiscal financing and liquidity management than the level of nominal interest rates. The Argentinean vigilantes have sent a message.

 

Source for all data: Bloomberg and Barclays Capital as of 24 Jan. 2018, unless indicated.

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