The only way is up

Mid-Week Bond Update

The only way is up

Global government and corporate bond markets suffered from one of the potentially most telegraphed US rate hikes in history: not only two Federal Reserve’s (Fed) rate-setting committee members said that an interest rate increase was likely next week, but chair Yellen also spelled it out...

rather clearly – further monetary tightening seems appropriate at this time. Market-implied chances of a March 14 hike jumped to reach a resolute 100%, compared with 45% only last week. Other countries added to the brighter global outlook: Eurozone inflation reached 2% for the first time since 2013; China’s foreign reserves rose for the first time in 7 months, and the UK shrugged off Brexit woes, raising its 2017 growth forecast to 2%, above a previous 1.4%. The US dollar rose against most major currencies, except the Mexican peso, which rallied 2.5% against the greenback after comments from the new US Administration about bringing stability to the exchange rate. The currency has recovered almost half the value it lost against the dollar following the US election in November. The South African rand also rose, and the country’s debt was the best-performing local sovereign Emerging Market, up 1.5% over the past 5 trading days. Some investors expect the central bank will cut rates for the first time since 2012, as Africa’s largest economy shrank a worse-than-expected 0.3% in the fourth quarter.

EM local sovereign bonds were one of the few fixed income asset classes to post positive returns over the past 5 trading days on generally improved fundamentals, and as they don’t use the rising US Treasury yield as a base. Most corporate spreads tightened, but the rising underlying US Treasury rate more than offset the spread improvement. US loans delivered profits on expectations that lenders will soon be able to pass the forecasted higher rates onto customers. Long-dated US Treasuries suffered most as they are more vulnerable to rising yields. 


ON THE RISE

Greenback, greenback – oh greenback my money to me: Despite the fact that the US dollar is 18% overvalued according to the Bank of International Settlements (the bank of central banks), the greenback continued its ascent against most major currencies over the past 5 trading days. Analysts forecast it will continue to do so during the rest of the year, only surpassed by the Czech koruna, the Swedish krona, the Norwegian krone and the British pound, among major currencies, as shown in the chart. A rate hike, as markets expect next week, tends to make US assets more attractive, lifting demand for the currency. This is especially the case when relative to Europe and Japan, which still hold negative rates in order to kick-start their economies. The dollar is also strengthening on the back of positive data. This week, for example, it posted higher imports, a sign of strong domestic demand, and rising exports, something which is helping buoy the until now dormant manufacturing sector. As much effort as the new Administration puts in talking down the currency (as other regions do), a weak currency rarely comes with a strong economy. Click here to read more about Western Asset’s views on the US economy.

 

US dollar: high hopes  (Forecast return vs US dollar by end of 2017)

Source: Bloomberg as of 8 March 2017. Data based on consensus forecast from analysts. Please find definitions in the disclaimer.

 

Euro High Yield – new awakening? The European High Yield (HY) market extended gains over the past 5 trading days, taking its 12-month return to 11%, becoming one of the few survivors in a generally falling fixed income market. European companies are benefiting from a finally improving economy, following years of practical stagnation. Germany’s Industrial output, for instance, surprised to the upside, rising 2.8% month-over-month in January, well ahead of expectations. The billons of euros that the European Central Bank is spending to stimulate the economy seem to be having an effect: inflation reached the central bank’s target of 2% in February - a level not seen since January 2013. While still one quarter of the size of its US equivalent, the European HY sector has seen an increase in issuance, with 17.1 bn euros worth of new bonds since Jan. 1st, the highest also since 2013 (compared with the same periods). Some US companies are choosing to sell HY bonds in Europe (known as reverse yankee bonds), given the lower interest rates. Click here to read more about Brandywine Global’s views on the global HY market.

 

ON THE SLIDE

 

Stocks & bonds – broken ties: The correlation between US stocks and government bonds has sharply fallen to a point close to 0 (minimal correlation), a contrast with previous years, in which the two asset classes seemed to move in tandem. This was a consequence of central banks’ big footing on financial markets, causing the quasi-bipolar “risk on/off” modes that have mostly prevailed since the 2007/08 crisis. With US rates on the rise and the Fed planning to reduce the Treasury holdings it has accumulated since the crisis, correlations are dropping across the board, making assets move more in accordance with their own fundamentals than with general market modes. As shown in the chart, stocks and bonds have a natural negative correlation: when bond prices rise, or yields fall, stock prices tend to drop, and viceversa. This changed after 2007-2008, when both asset classes were underpinned by billions of dollars of monetary stimulus, and they both soared. This relationship seems to have, for the moment, broken and dipped into negative levels – only seen in generally optimistic times.

 

Where have the correlations gone?

Correlation:

 

Source: Bloomberg as 6 March 2017. The spread used is between German and French 10 year sovereign yields. RHS is right hand side. Please find definitions in the disclaimer.

 

South Korean won - lost: The Asian currency dropped 1.3% against the US dollar over the past 5 trading days, trimming its year-to-date gains to 5.4%. The currency, which is 11% overvalued according to the Bank of International Settlements, is suffering from a number of negative forces: the economy is very exposed to global trade, especially to its big neighbor, China. However, future trade improvements may be limited: The China National Tourist Administration has recommended travel agencies to stop selling tours to South Korea, a response to the country’s construction of an anti-missile facility, perceived in China as a security risk. China tourism is an important source of demand for the South Korean economy – with 8.1 million Chinese visitors last year. The country could also be vulnerable to any move toward protectionist policies by the US.

 

Source for all data: Bloomberg and Barclays Capital as of 8 March 2017, unless indicated.

 

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