reflation en marche?

Mid-Week Bond Update

reflation en marche?

Most global bond markets had a dismal patch as a perfect storm of falling political risk, higher economic optimism and improved US corporate earnings drove equity prices higher, dampened volatility and reduced demand for traditional safe-havens. Emmanuel Macron’s En Marche! party’s victory in the...

French election over anti-euro leader Le Pen all but wiped out concerns of a European Union (EU) break up, clearing the way for the ongoing reflationary trend. Ignited by China’s stimulus programme last summer, this reflation push could be the one that finally drags the world economy out of its post-financial crisis hole, according to Brandywine Global. Only select, growth-sensitive fixed income asset classes delivered positive returns over the past 5 trading days, including European High Yield, US mortgage-backed securities and US corporate loans. The US Federal Reserve (Fed) added to the optimism last week by holding to its plans to hike rates twice more this year, despite disappointing first-quarter data, which it dismissed as temporary. Market-implied chances of an interest rate increase at the next Fed meeting on June 14 rose to a resounding 100%.

Although a strong US jobs report on Friday backed this view, US inflation expectations fell as some data, such as wage growth and the Institute for Supply Management (ISM) Manufacturing Index, remained soft. Renewed tension around North Korea and the abrupt dismissal of the Federal Bureau of Investigation (FBI) director also limited the Treasury yield rise. The benchmark US 10 year Treasury yield traded at 2.37% on Wednesday, up from 2.28% last week. The US dollar rose against most currencies, especially Emerging Markets (EM), which also suffered from plunging oil prices. Click here to read Western Asset’s views over which markets could offer opportunity in this environment.


Mexico: what you get is not what you see: The Mexican peso was battered again this week, falling below 19 pesos per greenback, hit by a rising US dollar and falling oil prices. The oil-exporting currency is also suffering from US president Trump’s plans to build up trade barriers between the two countries. However, this negative sentiment could be masking a different underlying reality: 1) Despite his previous vehement protectionist stance, Trump now appears more willing to renegotiate the North American Free Trade Agreement (NAFTA), instead of leaving it. 2) As shown on the chart, Mexican exports are closely correlated to US manufacturing: the US recovery helped Mexican exports surge 14% in March, the fastest pace since 2012. 3) Fundamentals are improving: stronger exports should help the country reduce its external borrowing needs; business confidence has improved, and retail sales and consumer credit are rising. 4) As shown further below, the correlation between the peso and oil has considerably dropped. 5) Despite a concerning 5.8% annualised inflation rate, the Bank of International Settlements, the bank of central banks, says the peso is 21% undervalued.


Friends, not enemies: US growth buoys Mexican exports

Source: Bloomberg as of 10 May 2017. ISM stands for Institute for Supply Management. RHS is right hand side. Please find definitions in the disclaimer.


European and Asian High Yield – Week survivors: Non-US High Yield (HY) indices were one of the few asset classes to post gains over the past five trading days, boosted by a better global outlook. Equity-like HY bonds tend to be more sensitive to economic sentiment than their investment grade peers as strong growth considerably reduces default risk. HY assets have higher risk of missing coupon payments, as expressed by their lower rating. European HY indices led gains, followed by Asia, lifting their year-to-date returns to 3.9% and 4.2%, respectively, matching and above the 3.9% returned by US HY. The US asset class has been dragged down by falling oil prices, as the industry is more heavily represented in the US than in the European and Asian indices. Economic sentiment is also improving in Europe on the back of stronger economic data, more political stability and central bank support.



EM currencies / commodity correlations – parting ways: EM currencies fell against a rising dollar over the past 5 trading days, also hit by plunging commodity prices. Oil fell to US$ 46 per barrel, down from $53 last month, mostly due to over-supply concerns. This drove down currencies of oil exporting countries, such as Colombia, Mexico, Brazil and Russia. The price of metals such as copper, palladium and aluminium has also dropped between 3% and 5% over the past 30 days, driven by mixed Chinese economic data. This has hurt the Chilean peso and the Australian dollar, both sensitive to China’s metal appetite. However, this reaction could have been overstated: as seen in the chart, the correlation between EM currencies and their relevant commodities has abated since last summer, when China announced the stimulus programme that ignited the global reflationary trend. Since then, currencies and commodities have parted ways, with the former being more linked to their own fundamentals. According to the Bank of International Settlements, the Mexican peso, South African rand, Brazilian real and Russian ruble are all undervalued against the US dollar.


Their own way: EM currencies’ correlation with commodities sinks

(A -1 correlation means assets move in perfect opposite direction, while zero indicates no relationship)

Source: Bloomberg as of 10 May 2017. WTI is West Texas Intermediate oil; Aust. Is Australian; Brent is a type of oil; SA is South Africa. Past performance is no guarantee of future results.


German bund yields - stimulus speculation weighs in: Traditionally rock-solid German sovereign bonds, known as bunds, seem to have lost a bit of their safe-haven flair. After touching a negative 0.19% yield last summer, many investors believed yields couldn’t fall much further. Indeed, the 10-year bund yield has now crept up to a positive 0.4% - and could continue rising given the improved European economic outlook. Following Macron’s French election victory, and the subsequent drop in political risk, investors have been quick to move to the next concern: speculation is now mounting that the European Central Bank will soon start reining in its monetary stimulus – which at present mostly benefits German bunds.


Source for all data: Bloomberg and Barclays Capital as of 10 May 2017, unless indicated.



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