Goldilocks is back

Mid-Week Bond Update

Goldilocks is back

Global sovereign and corporate bonds rallied over the past five trading days, as the recent central bank hawkish tone reversed and stubbornly soft US data threw cold water over reflation hopes. The goldilocks scenario in which growth is weak enough to warrant low rates but strong enough to...

drive corporate profits, returned to markets, fuelling bond and equity prices. The new narrative was triggered by the fourth consecutive weak US inflation print and as Federal Reserve (Fed) chair Janet Yellen questioned last week whether the temporary blip in inflation is that temporary after all. In addition, US retail sales fell in June and president Trump failed to pass a new Health Care bill, raising questions about his ability to pass his proposed tax cuts through Congress. Reflecting such bleak outlook, the US dollar sank to its lowest level in almost one year. This lifted Emerging Market (EM) currencies, which were also buoyed by Chinese data: the world’s second-largest economy posted second-quarter Gross Domestic Product growth of 6.9%, beating expectations and easing concerns about a hard-landing. The yield differential between the US and other developed market rates narrowed, not only because expectations of higher US rates faded, but also because those of other countries increased as global growth picks up. The Australian dollar was the best-performing developed market currency against the US dollar, up 4% over the past 5 trading days, as investors bet Australia will be the next country to lift rates, after Canada did last week. The Canadian currency extended this month’s rally, up 2.6% against the greenback over the past 5 trading days.


ON THE RISE

Emerging Markets - rate cut hopes: Emerging Markets had a bumper last 5 trading days, mostly fuelled by their rallying currencies. The benchmark JP Morgan Global Bond Index of local Emerging Market debt returned 0.7% over the period in local currency terms, but gained 2.8% when translated into US dollars, given the rally in EM currencies. The South African rand, for instance, soared 5% against the greenback, partially driven by the country’s internal debate over potential restrictions on the renewal of mining rights. The country’s local sovereign bonds also rose as inflation fell to the lowest in one and a half years. Lower inflation prints in select Emerging Markets, such as India, Brazil and Russia, are increasing investors’ expectations that central banks have further room to cut interest rates. As seen on the chart, the difference between the policy and the inflation rate is much wider in EMs than in developed markets, which have had record low rates since the financial crisis.

 

Cuts and cut-nots: EMs have more margin to cut rates

Source: Bloomberg as of 19 July 2017. CPI is Consumer Price Index; YoY is year-on-year. Policy rate is the main central bank interest rate. Past performance is no guarantee of future results. Please find definitions in the disclaimer.

 

UK - Pride and Prejudice: Just as the Bank of England unveiled a new 10-pound note bearing the image of Jane Austen, June inflation unexpectedly dropped to an annualised 2.6%, below market expectations of 2.9%. Mirroring one of the titles of the famous 19th century novelist, gilt prices rallied with pride, defying the prejudice that had sank them previously as Britain started negotiating its departure from the European Union (EU). At 1.19%, UK 10-year sovereign yields now stand half way between those in northern Europe, which remain near record lows (Germany’s is at 0.5%), and those on the region’s periphery, such as Italy and Spain (at 1.5%), for which investors demand higher premiums. Looking ahead, some investors suggested printing the title of another Austen novel on the new bank note: “Sense and Sensibility.”

 

ON THE SLIDE

US rate hike hopes – going flat:  The new batch of soft inflation and retail sales data pushed down expectations that the Fed will lift interest rates once more this year, as it plans. Market-implied chances of a rate hike at the central bank’s next September meeting have fallen to 19%, down from 49% in May. As many as 80% expect no rate action at all. It would not be the first time that the Fed changes gears if it refrains from rising rates – it would even be normal. Between 2014 and September 2016, the Fed consistently cut its median interest rate forecast, as unconvincing data failed to match the central bank’s more optimistic expectations. Rather than listening to the Fed, some investors prefer to look at the country’s yield curve, which is depicting a less rosy picture: the difference between the US 30 and 10-year Treasury yields has fallen to 58 basis points (bps), substantially flatter than when it reached 80 bps following Trump’s election in November. A flatter curve usually signals moderate growth ahead. US long-dated Treasuries gained 1.5% over the past five trading days.

 

The Fed vs the markets: belief in a 2017 rate hike fades

Source: Bloomberg as of 19 July 2017.The chart refers to the market-implied possibility of an interest rate increase at the Federal Reserve’s next meeting in September. Please find definitions in the disclaimer.

 

European inflation fears – not there yet: Following a streak of positive data that fuelled speculation about the European Central Bank’s (ECB) potential tapering of its monetary stimulus, the region’s inflation softened in June, to an annualised 1.3%, from 1.4% in May. Investors’ confidence also dropped in Germany, Europe’s economic engine, for a second month in July, helping cool down fears of a turnaround in Europe’s ultra loose monetary policy. ECB president Mario Draghi has recently reassured investors that Europe’s ailing growth still needs plenty of support.

 

Source for all data: Bloomberg and Barclays Capital as of 19 July 2017, unless indicated.

Top

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.