Politics: Pricing the New Normal

Mid Week Bond Update

Politics: Pricing the New Normal

Perspectives on bond premia in a politically-charged environment.


Political risk is notoriously difficult to anticipate, and a particular challenge for bond market pricing. Yet understanding how much of a given sovereign bond’s spread is due to transient political factors is in principle important to evaluating if a bond is mispriced.

An old rule of thumb was that market-shaking geopolitical events occur about twice a decade. However, this type of risk has become much more frequent over the past few years. That’s especially true of emerging markets (EM), whose economies are highly dependent on trade and whose politics have traditionally been more volatile than the overall global stage.

One independent research finding recently highlighted by Brandywine Global suggests the trailing effect of geopolitical shocks has lasted for as much as six months or longer, and has had the effect, at least for dollar-denominated sovereign bonds, of adding about 20 basis points over that period, standard warnings about past performance and future results notwithstanding.

Political Risk Premium Priced into Sovereign Bonds

Chart courtesy of Brandywine Global. Sources: Refinitiv, Capital Economics. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.


This finding is cold comfort for EM investors who have endured several recent downdrafts.  But it does serve as a reminder that focusing on short-term price movements can sometimes come at the expense of an investors’ longer-term return.
 

On the rise: Shorting of 10-year U.S. Treasuries

The Chicago Board of Trade (CBOT) tracks the futures contracts traded on the its exchanges – classifying traders as “commercial” or “non-commercial”. The non-commercial business is considered the domain of traders seeking to profit from the price movements of these contracts, rather than investors using them to offset the risks underlying holdings.  The distinction means more in the market for agricultural commodities than for Treasury futures, but it nevertheless allows for the measurement of “speculative” interest in Treasuries.

As of May 28, 2019, the most recent figure available via Bloomberg, net short positions in 10-year Treasury note futures has grown to about 376,000 contracts, or roughly $47 trillion. As recently as September 2018, the net short position had reached a near-term peak of 766,000 contracts. But that’s a notable increase from the recent low seen in the week of January 22 of 126,000 contracts.
 

On the slide: Treasury yield curve

The 3-month / 10-year segment of the U.S. Treasury yield curve has been inverted for eight days (i.e., the slope has been negative) since falling below zero on May 23, renewing recession fears; the slope reached as low as -27.2 basis points on June 3, and now[1] stands at -22.7 bps. With a notably dovish set of comments coming from FOMC governors, including Fed Chair Jerome Powell, and a Fed Funds futures market priced as if there will be two rate cuts in the remainder of 2019, it’s far from clear if the inversion will be long-lived.

Less carefully followed: the term premium for 10-year Treasuries. Term premium is a measure of how much an investor would earn by holding a 10-year Treasury note, vs continuously “rolling over” short-term T-bills.

In  theory, the term premium should be positive if the time value of money is greater than zero for holders of the  note.  But it stood at an all-time record low of -91 basis points as of May 30, the  most recent figure available from the Federal Reserve Bank of New York.

At least for now, that suggests short-term money appears to be worth more to the market than taking on a full-faith-and-credit risk for the next decade – less than a ringing endorsement of the longer end of the yield curve.

 

 


1 Source: Bloomberg, June 4, 2019, 3:33 PM ET

All data Source: Bloomberg as of June 4, 2019 unless otherwise specified.


Definitions:

Emerging markets (EM) are nations with social or business activity in the process of rapid growth and industrialization. These nations are sometimes also referred to as developing or less developed countries.

The yield curve shows the relationship between yields and maturity dates for a similar class of bonds.

Inverted yield curve refers to a market condition when yields for longer-maturity bonds have yields which are lower than shorter-maturity issues.

One basis point (bps) equals one one-hundredth of one percentage point.

The Federal Open Market Committee (FOMC) is a policy-making body of the Federal Reserve System responsible for the formulation of a policy designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.

The Federal Funds rate (Fed Funds rate, fed funds target rate or intended federal funds rate) is a target interest rate that is set by the FOMC for implementing U.S. monetary policies. It is the interest rate that banks with excess reserves at a U.S. Federal Reserve district bank charge other banks that need overnight loans.

 

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