Game of bonds

Mid-Week Bond Update

Game of bonds

Global sovereign and corporate fixed income markets rallied over the past five trading days, boosted by a combination of tailwinds: 1) Further White House infighting echoed Tv-soap operas, raising concerns about President Trump’s ability to deliver his proposed tax cuts, and therefore...

boost growth; 2) The US Federal Reserve (Fed) fully acknowledged that inflation is not somewhat, but definitely below target – a comment that the market perceived as dovish and that helped push US Treasury yields lower: the benchmark 10 year yield traded at 2.25%, down from 2.38% less than one month ago; 3) China posted above-expected economic growth of 6.9% in the second quarter, helping boost Emerging Market (EM) bonds. 4) A deluge of EM rate cuts (Brazil, Colombia, India, South Africa) also buoyed EMs; 5) The European Central Bank reaffirmed, again, its commitment to the present accommodative policy.

All the above fuelled a bumper week for the asset class, which continues to profit from a backdrop in which economies are strong enough to deliver growth and profits, but weak enough to keep rates low. In the US, market-implied probabilities of a rate hike in September fell to 14%, down from 35% in May. This less optimistic scenario lifted long-maturity Treasuries, which gained 1.2% over the past five trading days – the second-best performing fixed income asset class among the 33 tracked by the Mid-Week Bond Update. EM inflation-linked bonds topped the list, up 1.6% over the same period, partially driven by the recent rate cuts, especially in Brazil. The US dollar fell to its lowest level since May 2016, particularly against the euro, which rallied 1.8% over the past five trading days. The European currency, up 13% vs the dollar so far this year, has been underpinned by the unexpected strength of the region’s recovery. The International Monetary Fund (IMF) upgraded the Eurozone’s growth projections for this year and next, while cutting those for the US.



Europe and EMs – IMF support (the good one): In its influential semi-annual outlook, the IMF lifted its economic growth projections for the Eurozone, Canada and Emerging Markets, while cutting those for the US. On Europe, the lender said that positive surprises to activity in late 2016 and early 2017 point to solid momentum. Regarding EMs, the IMF highlighted China on the back of a strong first quarter and expectations of continued fiscal support. The Fund also stressed recent supply-side reforms, such as the country’s aim to reduce excess capacity in the industrial sector. On the other side, the organisation cut its US growth projections to reflect the assumption that fiscal policy is expected to be less expansionary than anticipated. Please click here to read why Western Asset thinks that EMs may offer investors some of the best opportunities.


IMF tributes EU, EMs growth – shames US, UK

(1st chart: expected economic grotwh (%) 2nd chart: change from April (%)

Source: IMF, July 2017. Latam & C. is Latin America & Caribbean. Past performance is no guarantee of future results. Please find definitions in the disclaimer.


US bank debt – 3 of 5 top slots: As many as three different tranches of debt issued by US banks take the top five slots in the country’s investment grade performance ranking by sector. Subordinated debt, for instance, has added as much as 0.5% so far this month, taking its year-to-date gain to 7.1%. Tier 1 debt, which is backed by a bank’s core capital, is up 9.2% this year, after adding 0.2% in the first days of August. Bonds issued by US financial institutions have been boosted by a recovering domestic economy, recent and projected interest rate hikes, which improve their margins, and generally better capitalised institutions.



EM interest rates – matching lower inflation: As many as four leading EMs (Brazil, Colombia, India and South Africa) cut rates over the past two weeks, a move aimed at spurring growth and also a reflection of their central banks’ success at keeping inflation at bay. Brazil, for instance, cut its benchmark Selic rate by 100 basis points to 9.25% last week, as annualised inflation has fallen to 3%, the lowest since 2007. Earlier this week, India lowered its base rate to 6.00%, from 6.25%, after annualised consumer prices dropped more than expected to 1.5% in June, well below the central bank’s target of 2% to 3.5%. While lower energy prices have helped EMs control once-spiralling price increases, better central bank governance and improved economic policies have also driven the inflation triumph. Still, the gap between rates and inflation is wide in some EM countries, giving investors hope that the cuts are not over yet. In contrast, and as seen on the chart, some developed markets seem poised for hikes as inflation is above the interest rate level.


EM rates and inflation – still room to cut? 

Source: Bloomberg as of 2 August 2017. CPI is Consumer Price Index, YoY is year-on-year. Past performance is no guarantee of future results. Please find definitions in the disclaimer.


Defaults – less faulty: High Yield bonds continued to rally over the past five trading days in both Europe and the US, fuelled by prospects of moderate rate growth and improving economies. The gains have also been fuelled by falling default rates: in the US, the biggest High Yield market, only one company defaulted on its debt in July, the lowest monthly total since March 2015, according to JP Morgan. So far this year, and including distressed transactions, defaults total US$20.3bn, less than half of last year’s $51.8bn. US HY bonds have gained 6.1% so far this year, while Europe’s are up 4.7%.


Source for all data: Bloomberg and Barclays Capital as of 2 August 2017, unless indicated.


IMPORTANT INFORMATION: All investments involve risk, including loss of principal. Past performance is no guarantee of future results. An investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice.  Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not  take into account the particular investment objectives, financial situation or needs of individual investors.