Long bonds win tax cut race

Mid-Week Bond Update

Long bonds win tax cut race

US equity markets responded with enthusiasm to US president Trump’s social media publicity of his proposed tax cuts, but the response from bond markets was more muted as investors scratched their heads over the implications of the plan. Contrary to widespread expectations, long-maturity Treasuries beat their shorter-term counterparts over the past five trading days, as some investors speculated...

that the expected lower corporate taxes and faster economic growth might be positive for long bonds: less tax could lift the amount of corporate investment, increasing the physical stock of capital, therefore reducing its returns as there is more of it – and therefore dragging down yields. Over a 12-month period, which has included as many as three rate hikes and great effort to kick-start the US economy, long-maturity Treasuries have returned 10%, more than any other Treasury maturity.

Global investors started focusing on next week’s Federal Reserve (Fed) meeting, for which there is a resolute 100% market consensus of a 25 basis-points rate hike. The next Fed move, however, seems to be more questioned as the Fed’s view widely differs from what is priced in future markets (read below). The US dollar gave mixed signals over the past five trading days as, despite the optimism over the tax cuts, data remained lacklustre: while both personal spending and income data for October showed steady gains, they continued the theme of slow and steady inflation growth. This led to a mixed US dollar performance, which let Emerging Markets (EMs) continue a positive streak, especially the Turkish lira. The lira rallied 3% against the US dollar over the past five trading days after Standard & Poor’s said interest rates in the country could rise as much as 100 basis points. Turkey’s inflation jumped last month to its highest since 2003.



The Fed vs the markets – different views: The US central bank and investors seem to be in full agreement about an interest rate hike next week. The picture afterwards, however, is starkly different. As seen on the chart below, the Fed sees interest rates at a median of 2.12% at the end of 2018, and 2.688% at the end of 2019 – well above the futures markets’ implied rates of 1.85% and 1.98%, respectively. This happens, partially, as the Fed believes that low inflation may be temporary, while some investors, such as Western Asset, are not that convinced and prefer to look at the yield curve for guidance: on Wednesday 6th, the difference between the 10 and 30-year Treasury yields fell to 37.8 basis points, the lowest since the end of 2008 – a signal of relatively low growth and inflation ahead. Click here to read the views of Western Asset’s Ken Leech about what the US yield curve is telling us, and what opportunities may arise. 


You say arriba, I say abajo – the Fed vs the markets


Source: Bloomberg Barclays Capital 6 Dec. 2017. FOMC is the median estimate from members of the rate-setting Federal Open Markets Committee. Please see disclaimers for definitions.


South African rand – political hopes: The South African currency extended its rally, taking it to a surge of 7.5% since mid-November. The optimism comes as deputy president Cyril Ramaphosa has won strong support to succeed president Zuma as party leader, on the perception that he would be more market-friendly and bring more stability, with fewer government reshuffles. The rand sharply fell in March after president Zuma abruptly sacked former finance minister Pravin Gordhan while he was in the middle of a roadshow in London. The leadership vote will take place at the forthcoming African National Congress’ summit, which runs from Dec. 16 to Dec. 20. The rand also gained after the country’s debt was only downgraded by Standard & Poor’s, but not by Moody’s, as expected.



Global correlations – the truth, exposed: The correlation between different global asset classes is falling, as economies finally recover from the aftermath of the global financial crisis and fundamentals replace the more simplistic risk-on / risk-off modes. The International Monetary Fund recently reaffirmed the upswing in global economic activity, with global growth projected to rise by 3.6% in 2017 and 3.7% in 2018. As seen on the chart, falling correlations has been positive for traditional riskier asset classes, such as Emerging Markets, with the exception of 2013, when the first signal from the Fed about future interest rate hikes sent the greenback soaring, hitting EMs. Other than that, when correlations have fallen, EMs assets have performed positively as investors focused on their true fundamentals instead of seeing them as proxy of risk.


Not a risk proxy: lower correlations better highlight EM truths


Source: Bloomberg as of 6 Dec. 2017. The JPM GBI Index is the JP Morgan Global Bond Index of local EM sovereign bonds. RHS is Right Hand Side. Past performance is no guarantee of future results. Please find definitions in the disclaimer.


UK pound – divorce tensions: Sterling reversed its November rise, dropping 0.8% so far in December, as tensions over the Irish Republic’s border with Northern Ireland stalked Britain’s talks with the European Union (EU) over the country’s planned departure from the trading bloc. The tensions come as the Democratic Unionist Party, which gives support to UK prime minister Theresa May’s government, is demanding changes on what the border between Northern Ireland and EU-member Republic of Ireland should look like. Despite the tensions, the pound has recovered some of the lost ground since Britons voted to leave the EU in June last year: the currency is down 8% since then, compared with the 18% it lost within the six months following the decision.


Source for all data: Bloomberg and Barclays Capital as of 6 Dec. 2017, unless indicated.



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