La la land, no more?

Mid-Week Bond Update

La la land, no more?

US Treasuries and traditional risk assets emerged as both 5-day and January winners, as US president Trump’s stark first policies added volatility and uncertainty, but also rekindled hopes of faster growth. Street protests, the firing of a high level official and several diplomatic spats...

pushed investors into traditional safe-havens, such as Treasuries and the yen, eroding some of the Trump-bump rally that had driven markets since the Nov. 8 election. The US dollar fell to its Nov. 10 level, wiping about half of its post-election gains. The shift in mode, which vindicates those who said the optimism was overdone, buoyed the asset classes which fared worst in the aftermath of the election, such as Emerging Markets (EMs). Also backed by the US dollar’s plunge, EMs have now mostly recovered their pre-election levels, in local currency terms, while narrowing losses to 3.3% when translated into US dollars.

Protracted lacklustre US data pushed High Yield spreads higher towards the end the month, although the asset class’ traditional higher coupons more than offset any price loss, ending January 1.4% higher. Sterling and European sovereign bonds were both 5-day and 1-month losers, dragged down by soaring inflation expectations: in the UK, this was mostly fuelled by a falling currency and higher import prices, while in Europe, higher sovereign yields came on the back of strong economic and inflation data - and a French political scandal. European corporate spreads tightened, given the region’s improving economic outlook. Brazil’s local sovereign bonds were January’s top large-EM performer, up 3.2%, and taking their 12-month return to 36%. Investors are still lured by the 75 basis point-rate cut in mid-January, on the back of more contained inflation. Also, some investors are favouring EMs with trade deficits with the US, such as Brazil, as they could be less hit by Trump’s planned protectionist policies.



Currency wars - Friends and enemies: US criticism that Europe and Asia are keeping their currencies artificially low in order to boost exports intensified over the past few days, prompting diplomatic pushback and driving the greenback lower – perhaps an intended consequence. The rhetoric worked in the case of the Mexican peso, which soared 3.7% against the greenback, but barely moved the euro and the yen – both barely up 0.2% against the dollar over the past 5 trading days. The Chinese yuan continued its downwards slide, taking its 12-month drop to 4.4%. The countries criticised by the new US Administration for keeping their currencies low echo the list of countries with whom the US runs a trade in goods deficit, as shown in the chart. This has led some EM investors to favour countries on the surplus side of the US trade balance, as they could be less affected by the proposed tariff policies. 


Who’s my friend? Check the trade balance

2016 US Trade in Goods by country (USD billion)

Source: US Census Bureau. Latest data available: January to November 2016 (both included). Please find definitions in the disclaimer.


TIP, TIP Hurrah!  US Treasury Inflation Protected (TIP) bonds celebrated on Jan. 29 their 20-year anniversary with a modest 5-day gain of 0.3% - a reflection of the asset class’ steady but positive return profile. The first TIP auction, in 1997, came on the back of strong demand from pension and mutual funds eager to match their long-term liabilities. TIPs became popular, but later suffered from the 2007-08 financial crisis and the global deflationary period that followed. The asset class is now back in vogue as inflation expectations rise throughout the world – New York Federal Reserve data show that the fourth quarter had the highest average daily trading volume in TIPs ever, according to Barclays Capital. The asset class is also underpinned by a 190% cumulative total return since inception, through December 2016, outperforming Treasuries, mostly because of their longer duration and general drop in yields over the past 20 years. Equities and High Yield bonds have outperformed TIPs, but with much greater volatility.



Sell-off du jour - French spreads:  The risk premium that investors pay to hold 10-year French sovereign bonds over German bunds rose sharply over the past 5 trading days to a 3-year high of 62 basis points, a much faster pace than the rise in other European countries. In a global politically-sensitive environment, French conservative candidate Francois Fillon’s chances to win this year’s national election were diminished after reports that he illegally employed and paid his wife for fake work. His demise has propped up investors’ fears that anti-establishment and anti-euro candidate Le Pen might end up at the Élysée. The scandal added another problem to the European Union, which is also facing Britain’s departure from the club, along with ailing economic growth and a diplomatic quarrel with the US over trade.


Scandal is pricey – ask Fillon, and French bond holders

(Difference between Germany’s and the country 10 year yield, in basis points) 

Source: Bloomberg as 2 February 2017. RHS is right hand side. Please find definitions in the disclaimer.


UK bonds – inflation bites: UK sovereign bonds, known as gilts, lost 1.9% in January, their worst start to a year since 2013. Britain’s inflation expectations shot up 11% to 3.4% over the past five trading days, fuelled by surging factory costs. A measure of input prices in the monthly Purchasing Managers Index (PMI) jumped to its highest level since records began in 1992, largely driven by higher import costs. Sterling has plunged 14% since Britain voted on June 23 to leave the European Union. Parliament is holding this week the first vote on the bill that will trigger the exit.


Source for all data: Bloomberg and Barclays Capital as of 1 February 2017



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