The Fed vs the markets

Mid-Week Bond Update

The Fed vs the markets

Global sovereign bonds rallied over the past five trading days as oil plunged, inflation expectations sank and data remained soft – all of which led some investors to question the US Federal Reserve’s (Fed) rate hiking path. A string of disappointing inflation, exports and investment data has...

prompted some analysts to cut their US growth forecasts for this year, reducing overall market expectations that the central bank will raise interest rates once more in 2017, as expected. The gloomy mood lifted long-maturity Treasuries, which gained 2.5% over the past five trading days, more than any of the 33 fixed income asset classes tracked by the Mid-Week Bond Update. Japan’s and UK government bonds also performed well, supported by dovish comments from their respective central bank governors, keen to maintain loose monetary policies in order to boost growth. Italian sovereign bonds, particularly, rallied after the populist and anti-euro Five Star movement flopped in the local elections, reducing uncertainty in the country.

Political turmoil also abated in the White House, where the new Administration reassured plans to implement a tax reform aimed at buoying growth. This and some hawkish Fedspeak lifted the US dollar, which recovered most of the ground lost in June against other currencies. The greenback rose against Emerging Market (EM) currencies, especially those of oil-exporting nations, such as the Russian ruble and the Colombian peso. The Australian and New Zealand dollars were the only currencies to appreciate against the dollar over the past five trading days, on the back of consistent economic growth and some positive news from China, a key trading partner. The Asian giant was this week admitted into the leading MSCI Equity indices, a victory for a country that is in the process of opening up its capital markets.

 

ON THE RISE

US corporate bonds: angels & stars: US Investment Grade (IG) corporate bonds returned 0.7% over the past five trading days, well above the 0.1% offered by their European counterparts, whose yields remain anchored by the region’s ultra-low interest rates. Instead, yields are higher in the US, where the central bank has already lifted rates four times over the past 18 months, as the country is ahead of Europe and Japan in terms of economic growth. The extra yield offered by US credit is luring investors from other regions, improving the technicals of the asset class. Some investors believe that opportunity may lay at the bottom of the IG credit scale, which can include companies recently upgraded from High Yield, often called “rising stars,” but which may be overlooked given their non-IG past. The lowest IG-rated US corporates have returned 4.7% so far this year, slightly less than the top ranked Aaa-rated, up 5.1% over the same period, but above their Aa and A peers, which have gained 3.2 and 3.9%, respectively. Some investors also favour the so-called “fallen angels” or recently downgraded companies as the move might be temporary.

 

Yield hunt: Investors seek US corporate debt

Yield offered by IG corporates in the following regions: (%)

Source: Bloomberg as of 21 June 2017. Fed is Federal Reserve. RHS is right hand side. Past performance is no guarantee of future results. Please find definitions in the disclaimer. 

 

Argentina – century bond: The country successfully sold a 100-year sovereign bond despite having a history of defaults, and also despite selling the security in a week in which EMs suffered from a rising US dollar and commodities plunged. The move illustrates investors’ increased appetite for EM debt on the back of improving fundamentals, and as developing countries are expected to profit from a pick-up in global growth. The bond offers a yield of 7.9%, high enough to attract international investors, who still face negative sovereign yields in Switzerland and zero-level 10-year sovereign yields in almost half of Eurozone countries. The sale is also a sign of investors’ confidence in president Mauricio Macri’s planned reforms and economic changes. Since taking office in 2015, Macri has floated the currency and settled with investors involved in the 2001 country default, paving the way for Argentina’s return to international markets. 

 

ON THE SLIDE

Stocks vs bonds – whom to believe? Stocks and bonds used to move in different directions, as investors sought the traditional safety of coupon-paying debt when fatigued equity markets stopped pricing buoyant corporate profits. The situation has now changed and the two asset classes seem to reflect very different scenarios: as shown in the chart, falling bond yields depict a story of lame economic growth, at the same time that equity prices have been reaching record after record. Which one is right? A decade of monetary stimulus and billions of dollars, euros and yen poured into financial markets has inflated asset prices, perhaps making them less linked to each security’s underlying fundamentals. This is one of the reasons why central banks are keen to start normalising their policies: they want financial markets to better reflect what is really going on in the economy. The US has already started this process and Canada recently signalled it is ready to do so. Investors expect the European Central Bank to show signs of normalisation later on this year. At that point, stocks and bonds may start telling a different story. Click here to read which fixed income markets may offer attractive opportunities, according to Western Asset.

 

Different message: stocks’ optimism vs bonds’ gloom

Source: Bloomberg as of 21 June 2017. UST is US Treasury; yr is year; RHS is Right Hand Side. Please find definitions in the disclaimer.

 

Oil – deflating: Oil plunged to US$43.4 dollars per barrel, the lowest since September last year, as data showed US production continued to grow, gasoline stockpiles declined and countries such as Libya increased output. The move more than offsets the efforts from the Organisation of Petroleum Exporting Countries (OPEC) and its allies, including Russia, to cut production in order to lift prices. However, some observers have been warning for months that OPEC’s main enemy is not its own overproduction, but increased competition from US shale and clean energy producers. The slump in oil prices dragged down inflation expectations, boosting long-term sovereign debt.

 

Source for all data: Bloomberg and Barclays Capital as of 21 June 2017, unless indicated.

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