The emperor has no clothes?

Mid-Week Bond Update

The emperor has no clothes?

Just as in the old parable, the number of investors daring to challenge common belief seems to be growing: are president Trump’s promises to double economic growth really sustainable? Bond yields seem to be saying “no.”

The world benchmark US 10 year Treasury yield has fallen to 2.23%, the lowest since late November, while the yen recently reached its highest against the US dollar also since the election month. US inflation expectations are at year lows. This risk-off mode follows a week that included US air strikes over Syria, war ships deployed to North Korea and further White House political gaffes. But apart from the geopolitical tension, an unexpectedly dismal US jobs report also contributed to the general revision of the so-called Trump trade, or the belief that the new US Administration can deliver on its promise to double domestic growth soon. Markets are giving a clear answer: since Trump was sworn in as president on Jan. 20, all leading US fixed income asset classes, as well as Emerging Market bonds, have posted gains – hardly a sign of reflation. This is in stark contrast to the period between Trump’s election on Nov. 8 and Jan. 20, when only US High Yield, loans and non-agency backed mortgage bonds delivered positive returns, while US Treasuries sank as much as 7%, in the case of long-maturity Treasuries; equities rallied. Now, most fixed income asset classes have recovered their post-election losses and equities have come off recent heights. The trigger? Read “Reflation – revisited” below.

Over the past week, oil rose on the back of the Middle East tension, which on the other hand hit some Emerging Market (EM) currencies, such as the South Korean won and the Russian ruble. The EM currency drop was a negative for local EM bonds, when translated into US dollars, although the asset class was resilient in local currency terms. The Czech koruna was an exception, as it gained 0.9% against the dollar, over the past 5 trading days, after the central bank lifted the floor of its peg against the euro, letting the currency rally. The central bank has said deflation is no longer a threat, so it is less worried about a strong koruna making imports cheaper.


Yen – the new gold? The Japanese currency was the best-performing major against the US dollar over the past 5 trading days, reaching 109 units per greenback, the highest since the aftermath of the US election in November, when the dollar rallied. Investors are flocking to yen as much as they do to gold in times of trouble, as they are both perceived as safe-havens, but the yen, increasingly so: the correlation between the Japanese currency and gold reached on Tuesday April 11 a level of 0.74, the highest since at least 1975, when data records start. This is not good news for Japanese officials, though, who are trying to lift exports as a way to reignite a dormant economy that has been fighting deflation for 2 decades. Like Europe, Japan’s interest rates are at negative levels, an effort from the central banks to foster bank lending. Despite being at 0.024%, Japan’s 10-year Treasury yields have actually dropped 84% over the past 1 year period. Some investors believe such low level in Japanese and European yields will continue to push demand for US Treasuries. Click year for an around-the-world tour of fixed income markets by Brandywine Global.


All that glitters is not… yen

Source: Bloomberg as of 11 April 2017. RHS is right hand side. Please find definitions in the disclaimer.


UK linkers – for the long run: UK inflation-linked bonds were the best-performing fixed income asset class, among a select group of 33, with a 2.7% gain over the past 5 trading days. The move lifts their 12-month return to 27%, again the best of the class, and its 3-year one to a whopping 50%, only behind US non-agency backed mortgage bonds, up 52% over the period. Inflation-linked bonds, or linkers, as they are known in the UK, have done well over the past year as inflation is expected to increase given the drop in the pound since Britain voted last year to leave the European Union. Linkers, though, are also luring investors given their traditional long duration – a measure of interest rate sensitivity. Since the Bank of England isn’t expected to lift rates any time soon, longer-maturity bonds are expected to be more protected from interest rate changes. The main Bloomberg Barclays (BB) UK linkers index has a duration of 23 years, way above the 7 years of the BB Global Aggregate index, or the 4 years of US High Yield. Sterling-denominated bonds traditionally have longer maturities given the demand from pension funds, which need to match their long-term liabilities.



Reflation - revisited: The widespread reflationary hopes that pushed equity prices to records and sovereign bond (prices) to the floor seems to be abating. Apart from heightened geopolitical tensions, some investors are now questioning the true substance under the US economic recovery. For a start, and as seen in the chart, the current expansion, while long, is still far behind previous expansionary cycles in terms of real growth. Second, while inflation has indeed picked up and reached the central bank’s 2% target level, some investors, such as Western Asset, believe that inflation is mostly driven by rising house rental prices, while everything else remains practically flat (click here for Western Asset’s view of global bond markets). The capacity of the new Administration to materialise its promised reforms is also being questioned, given the recent failure to pass a new Healthcare bill through Congress. While soft indices, such as US consumer and business confidence neared multi-decade highs, so-called hard data, including housing, industrial and labour indices, remains inconclusive. This has pushed down US inflation expectations, with the 10-year rate falling to 1.9%, down from 2.07% in late January. This, combined with the drop in nominal yields, has dragged down real rates (the difference between nominal rates and inflation expectations) so far this year. A drop in real rates usually reflects poor economic sentiment.


The emperor has no clothes? 

US expansion is not as strong as previous comparable periods – and real rates reflect that.


And Bloomberg and Western Asset as of 11 April 2017. Yr is year. Please find definitions in the disclaimer.


French election – gloves off: It’s now 2 weeks to the first round of the French election and the risk premium that investors pay to hold French government bonds over German bunds has spiked to 73 basis points, up from 57 only 2 weeks ago. Investors are concerned about the increased popularity of not only far-right candidates, such as Marine Le Pen, but also now of extreme-left leaders, such as Jean-Luc Melenchon. The Communist-backed candidate’s chances of winning have soared to 9%, from practically nil last month, following a TV debate in which he fared well. The nation’s favourite continues to be the more moderate Macron, a former finance minister with the Socialists, with a 56% chance, according to the latest polls. Le Pen’s have recently increased to 27%, from a recent low of 24%. The two winning candidates in April will go tête à tête in a second round on May 7. Some investors are concerned that radical changes in France could threaten the stability of the entire European Union. Click here to read Western Asset’s Andrew Belshaw views over the French election, and here for a Legg Mason analysis of the rise of populism in Europe.


Source for all data: Bloomberg and Barclays Capital as of 12 April 2017, unless indicated.



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