Goldilocks data lifts High Yield, Emerging Markets

Mid-Week Bond Update

Goldilocks data lifts High Yield, Emerging Markets

High Yield and Emerging Market bonds were the winners over a 5-day period dominated by goldilocks data: a not too hot-not too cold economy has generally been positive for the two asset classes, which have traditionally benefited from...

a combination of moderate growth and low rates. Some investors bought into the asset class as weak US wage growth data confirmed previously contrarian (now more mainstream) views about the pace of US Federal Reserve (Fed) hikes this year. Market-implied probabilities that the Fed will raise rates at its next meeting in March fell to 22%, down from 33% in mid-January. Inflation expectations in all G7 countries fell over the past 5 trading days. The US 10 year Treasury yield, which largely determines the price of many goods and services in the world, fell to 2.35%, down from the almost 2.6% reached after the Fed lifted rates in December. US Treasury yields also fell following some far-from hawkish Fedspeak from chair Yellen (click here to read and watch what to expect from the Fed this year).

The US dollar ended the period practically unchanged, as a falling euro and sterling (dragged down by their own internal issues) offset gains from the yen and the Australian dollar: the latter, lifted by rising metals and mining prices; and the yen, by safe-haven demand and better economic sentiment: the job-to-applicant ratio increased to 1.43 in December, the highest since 1991. Oil dropped to US$51.7 per barrel on increased US stockpiles. This didn’t stop sovereign local bonds from oil-exporting Brazil from surging 1.8% over the past 5 trading days – the best performing within the asset class. Some investors were encouraged by recent below-expectations inflation data and hopes that the central bank has further room to cut rates (click here to read more about Brazil’s turnaround). In contrast, the Indian central bank changed its stance to neutral, from accommodative. European sovereign bonds were the worst performing asset class, among 33 fixed income sectors, dragged down by political uncertainty, renewed concerns over Greece’s solvency and disappointing German data.

 

ON THE RISE

Swaps - up at last: One of the most strange anomalies created in the aftermath of the 2007-2008 financial crisis has finally reversed its course: the US interest swap rate, or the interest that banks pay to borrow from each other (orange lines in the chart) is now back above Treasury yields, or the cost of borrowing from the US Treasury – in theory, a risk-free rate which charges no risk premium as it’s backed by the government. This anomaly happened as new and tougher bank regulations reduced the amount traded by banks, cutting down demand – and prices. Over the past few days, however, president Trump’s comments about a relaxation of banking rules has lifted the risk premium that borrowers demand to deal with financial institutions. This has taken the swap rate back above Treasuries, as seen at the 5-year level on the chart. Expectations of higher rates have also made some investors sell swaps, which act as a protection or hedge against potential rate changes. These sales have translated into wider spreads. Click here to read how Western Asset predicted this move in November 2015.

 

News: borrowing from banks is more expensive than from the Treasury  

Source: Bloomberg as of 8 February 2017. Please find definitions in the disclaimer.

 

Yield hunt? Latam, fertile ground: Latin American High Yield (HY) corporate bonds were the best-performing within the HY asset class over the past 5 trading days, up 0.7%, and taking their year-to-date return to 3.7% - again, top of the class. The region is gaining investors’ favour on expectations that it will be less challenged by a protectionist US than Asia, since countries such as Brazil and Argentina run trade deficits, and not surpluses, with the world’s no. 1 economy. Rising commodities are another tailwind: gold, silver and palladium are up 8%, 11% and 12% so far this year, respectively, while copper, corn, wheat and soybeans have also added c. 4.5%. Latin American corporate bonds, whose spreads rose as the US dollar rallied in 2014/2015, have not fallen back to their 2012/2013 levels as their Asian counterparts, and the overall EM corporate asset class, has. Growth and political goodwill are also behind the renewed interest: Brazil’s president Temer and his Argentinean counterpart Macri have met this week in order to revive Mercosur, the Latin American intra-trading project that faded as the region’s two leading countries fell into recession. It is now time to revive, they say.

 

ON THE SLIDE

Europe – haunted by ghosts again:  The risk premium that investors demand to hold French, Italian or Greek bonds over German bunds spiked over the past five trading days – a sign that old concerns about the European Union’s future are resurfacing. The moves have been particularly dramatic in France, where allegations that presidential candidate Fillon illegally employed his wife and 2 sons have raised the profile of anti-euro rival Le Pen. Greek spreads also shot up as a rift between top creditors the International Monetary Fund and the European Union could block another bailout deal. The region is also facing the process of losing one member, the UK, while still trying to reflate its ailing economy. Investors are increasingly worried that the rise of anti-euro parties in the region could threaten its unity further. The Netherlands, France and Germany are due to hold presidential elections this year. The euro was down 1% against a flat dollar over the past 5 trading days.

 

Spread the message: the message is the spread

(Difference between Germany’s and other European countries' 10 year yield, in basis points) 

Source: Bloomberg as 8 February 2017. RHS is right hand side. Please find definitions in the disclaimer.

 

China bonds – losing steam: A 0.9% drop made Chinese bonds the worst-performing EM local sovereign issuer over the past 5 trading days. The country hiked a range of policy rates, a reflection of the central bank’s intention to contain rapid credit growth and mitigate capital outflows. A falling currency (-4.2% against the US dollar over the past 1 year) has accelerated money outflows, as local individuals and companies seek higher yields and currency protection elsewhere. The government has tried to defend the yuan by spending some of its foreign exchange reserves, which fell in January to under US$3 trillion for the first time since 2011. Annual economic growth, however, has stabilised around the 6.7% level for more than one year.

 

Source for all data: Bloomberg and Barclays Capital as of 8 February 2017

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