Markets await Jackson Hole

Mid-Week Bond Update

Markets await Jackson Hole

Global fixed income investors remained subdued as they awaited for the annual central bankers’ gathering in Jackson Hole, Wyoming – hoping that the free money central banks have made available over the past few years lasts just a bit longer. Expectations that European Central Bank (ECB) president Mario Draghi would use the gathering to...

signal a tapering of the bank’s stimulus programme abated after some ECB members raised concerns about a stronger euro hindering export growth. The European currency stalled this year’s 12% rally against the US dollar over the past five trading days. The US currency, however, continued its slide, reaching its lowest level since May last year on the back of protracted White House trouble and unconvincing economic data: US new home sales fell to 571,000 in July, well below expectations of 610,000. This backdrop lifted US Treasury and developed market government bonds once again, with the benchmark US 10-year Treasury yield staying under the 2.2% level, far below the 2.6% reached in March. Back then, markets expected president Trump would carry out multiple reforms, including corporate tax cuts.

Emerging Markets (EM) remained resilient to geopolitical tensions. Yield hungry investors continue to pour money into the asset class, pushing yields to record lows. Over the past few weeks, CCC+ rated Mongolia, Ukraine and Belorussia have seen their bond yields fall below 6% - a first ever in Mongolia’s case. Investors seem to favour EMs over other traditionally riskier fixed income classes, such as High Yield (HY), whose spreads over Treasuries widened over the past five days. US HY spreads now trade at 386 basis points, up from 349 earlier this month. The real yield of US HY is around 4%, while Brazil’s sovereign debt, for instance, offers real yields of about 7.3%. Investors are choosing the latter.

 

ON THE RISE

EM Asia -  savouring the sweet spot: After being the poster-child of "what not to do" in economics - which led to the currency and Balance of Payments crisis of the late 1990s - Asia now seems to be the International Monetary Fund’s (IMF) best alumni. Almost two decades after multiple IMF rescue programmes in the region, EM Asian countries find themselves in a sweet spot of fast real growth (6% vs 2% in developed markets) and benign inflation (2.1%, vs 1.7% in developed markets). Countries are now enjoying the effects of lower oil prices and years of economic discipline, which are leading to falling sovereign bond yields, as seen on the chart. Lower inflation is also allowing central banks to cut rates to foster growth – this week, for instance, Indonesia lowered its lending rate to 4.5%, from 4.75%, as inflation stands at an annualised rate of 3.8%, below a real growth rate of 5.01%. Relatively stable growth in China is also supporting the region, which has also increased its foreign reserves to become more immune to external shocks. Click here to read why EMs may be more resilient to tighter US policy, according to John Bellows, of Western Asset.

 

Reaping the benefits – EM Asia bond yields drop as countries do their homework

Generic 10 year sovereign yields (%)

Source: Bloomberg 23 August 2017. RHS is right hand side. Past performance is no guarantee of future results. Please find definitions in the disclaimer.

 

Japan: are we nearly there? Japan’s currency surged 1.4% over the past five trading days, boosted by – for once – upbeat data. After a two-decade lethargy, it seems as if Japan’s economy is finally waking up: the country’s Purchasing Managers’ Index (PMI) came in at 52.8 in August, topping expectations, while second-quarter Gross Domestic Product (GDP) rose to 4%, the highest since March 2015. Benchmark 10-year sovereign bond yields are also back into positive territory, after being negative for most of 2016. The country’s central bank remains committed to its ultra-accommodative policy.

 

ON THE SLIDE

US and European financial conditions tighten – doing central bankers’ job? After a post-US election surge, both European and US financial conditions are tightening again, a sign that optimism and expectations of a quick pick-up in US growth are somewhat abating. Less expansionary conditions (including short-term rates, bond spreads and volatility) may give central bankers meeting in Jackson Hole more room to extend their accommodative policies, as markets are already imposing a tighter environment. Some ECB members, for instance, have raised concerns about this year’s euro rally, as this makes exporters’ lives a bit harder, something which could hinder growth. Stronger currencies can also contribute to tighter financial conditions – hence most politicians try to talk them down. This may challenge the (traditionally) trout-fishing central bankers in Wyoming this week, keen to lift rates in order to have some gunpowder ready if needed. The chart below may slow down their plans.

 

Jackson Hole watch: will tighter conditions give central bankers more time to hike?

Source: Bloomberg as of 23 August 2017. The indices used are the Bloomberg US and European Financial Conditions Index, which include indicators such as Libor, TED spreads, corporate bond spreads, equity prices and volatility indices. A positive value indicates accommodative financial conditions, while a negative value indicates tighter conditions relative to pre-2007 crisis levels. Past performance is no guarantee of future results. Please find definitions in the disclaimer.

 

Italian bonds – political uncertainty is back: Italian sovereign bonds were the outliers in the European sovereign debt market over the past five trading days, as they lost 0.4% while most European sovereigns posted gains. Politics came back into the fray in Italy after the anti-establishment Five Star Movement polled close to the more market-friendly Democratic Party ahead of a national election next year. Investors will be closely watching a regional election in Sicily in November for future signals.

 

Source for all data: Bloomberg and Barclays Capital as of 23 August 2017, unless indicated.

 

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