On Second Thought...

Mid-Week Bond Update

On Second Thought...

Global bonds mostly rallied as safe-haven thinking reasserted itself over the past week – thanks to geopolitical concerns as well as signs that U.S. growth may not fulfill the high hopes raised by Trump's election.

Global bonds mostly rallied as safe-haven thinking reasserted itself over the past week – thanks in part to recent saber-rattling by the United States and uncertainty surrounding the upcoming French election. But equally important are signs that U.S. growth may not live up to the high hopes that followed Trump’s ascension. U.S. inflation expectations fell to year lows, and 10-year Treasury yields dropped as low as 2.175%, the lowest since late November. It’s worth noting that between the Nov. 8 election and Jan. 20 inauguration, only US High Yield loans and non-agency-backed mortgage bonds delivered positive returns.  But since the inauguration, all leading U.S. fixed income asset classes (as well as Emerging Markets bonds) have posted net gains, in many cases wiping away their post-election losses.  In China, however, the economic news was happier, with year-over-year GDP growth coming in the strongest since 3Q 2015. In Europe, the Brexit saga saw a new chapter unfold with U.K. Prime Minister May seeking to consolidate her party’s power via a snap election before potentially divisive Brexit negotiations. 


ON THE RISE

Rate volatility – creeping higher:  The MOVE Index, which measures implied volatility on U.S. Treasury options, jumped notably in April – as much as 23% since the start of the month, after trending lower since a brief spike just after the November Presidential election.  This month’s leap was generally attributed to new wrinkles in geopolitical risk and unexpectedly weak U.S inflation data.  Unlike the November spike, the recent increase in volatility has come alongside falling 10-year U.S. Treasury yields, a testimony to their continued appeal as relative safe-havens. Western Asset believes that volatility is likely to persist—potentially creating opportunities for its active bond managers.

Interest rate volatility is rising amid falling yields

Bond volatility (via MOVE Index) and 10-year Treasury yields

Source: Bloomberg as of 18 April 2017. Please find definitions in the disclaimer

U.K. – Snap decision   Sterling saw a nice lift Tuesday, reacting positively to Prime Minister May’s surprise announcement that she would seek a snap election—one  that her Conservative party would presumably win handily, given its currently strong polling numbers.  The pound rose as much as 1.5% against the US dollar, before falling back a bit for a roughly 1.2% gain.  Yields on gilts (U.K. sovereign debt) followed a similar arc; 10-year yields briefly fell below 1% for the first time since October, but soon returned to their initial level of 1.05%.

China – stimulus drives GDP: China announced annualized GDP growth of 6.9% (year over year) for 1Q17, its best showing since 3Q15 – fuelled by the government’s policy initiatives, including monetary stimulus and infrastructure spending. However, the Chinese consumer was also a factor, as evidenced by a significant increase in household debt.   For fixed-income investors, solid growth in China helps assuage concerns about any imminent disruption in global credit markets that might have come with a weaker growth report.  

 

ON THE SLIDE

U.S. consumer prices – a bump in the road?  Widespread pricing weakness was evident in the March inflation, where CPI fell -0.3% from February, the first decline in a year. The monthly drop reduced the year-over-year gain for March to 2.4% down from 2.7% in February. Core CPI, which excludes food and energy prices, also fell in March -- down -0.1%, the first monthly drop since January 2010.  Whether the weaker-than-expected inflation report marks a real turn toward lower inflation, a continued low, stable pricing environment, or just a pause in a rising trend remains to be seen. In the short term, however, U.S. 5-year/5-year inflation expectations dropped to their lowest this year on Tuesday, receding to levels last seen in December.

Inflation takes a breather

U.S. CPI and Core CPI, March 2016 – March 2017

Source: Bloomberg as of 18 April 2017. Please find definitions in the disclaimer

Brazil – slash and turn? Brazil’s central bank cut its target rate (the SELIC) by 100 basis points last week, to 11.25%. That’s the largest reduction in 8 years, and the third this year. In contrast, the SELIC was holding steady at 14.25% six months ago. With the March inflation rate below 5%—down from more than 10% in February 2016—the bank is hoping that lower interest rate will help turn around an economy that has been seriously contracting for the previous two years.  Those hopes may already be turning into reality. The central bank’s monthly indicator of economic activity increased 1.31% in February, its biggest gain since 2010, and January’s level was revised up to 0.62%. With growth improving, the Brazilian real has strengthened versus the U.S. dollar—up 1.6% on Monday as the growth news was released, and up nearly 5% from the beginning of the year.  The current yield on Brazil’s 10-year government debt is still a little north of 10%, but that’s down from nearly 17% a year and a half ago.

Source for all data: Bloomberg and Barclays Capital as of 18 April 2017, unless indicated.

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