Radiografía del mercado de renta fija

Chris Iggo, AXA IM - Viernes, 24 de Febrero

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The yield on the US 2-year bond is now 2% higher than in the German market. By recent historical standards this is very high. It reflects, of course, the markedly different monetary cycles that the two economic blocs are in. The US is in a tightening monetary policy mode, made clear again this week by the Federal Reserve’s (Fed) minutes from its last meeting. Meanwhile the European Central Bank (ECB) has not taken its foot off the pedal in terms of its asset purchases. Throw in some political risk and the spread widening is clear. The euro/dollar exchange rate has been falling since the beginning of the year and could test the December’s lows of $1.04 before too long, especially if the French election continues to underpin volatility in the bond market. The move lower in German rates has reduced prospective returns from the European bond market in general. The US market looks better, and European equities look better than bonds. The search for yield in Europe has not got any easier.

New lows in Germany – By far the most interesting development in the bond market this week was the sharp decline in the level of yield in the German market. The yield-to maturity (YTM) on the 2-year German government bond fell to -90 basis points (bps), a full 50 bps below the ECB’s deposit rate and more than 2% lower than bonds of equivalent maturity in the US Treasury market. The spread between the US and Germany has not been as high since 1997 which resulted from 3 year’s-worth of monetary tightening from the Federal Reserve. At the time, the dollar responded very positively to the growth in the short-term interest rate differential. At the end of 1994 the US dollar (USD) was worth 1.4 Deutsche Marks. By the end of the 1990s, just as the euro was introduced, it was worth 2.2 Deutsche Marks. The interest rate differential today is closing in on the levels reached back then, a reason why so many market participants remain bullish on the dollar. When we also consider the potential for fiscal stimulus along with more US monetary tightening and also the potential political uncertainties in the euro area, it’s hard to argue against a stronger buck. The only two things I would say here is that being long USD in the currency markets is pretty much a consensus trade and, secondly, that Donald Trump is prone to say he wants a weaker dollar to help American businesses.

 

Not in the reflation script –  The further decline of short term yields into deeper negative territory does not, at first glance, fit with the narrative of global reflation. However, seen in the context of the widening spread between US and European rates, the narrative is that while the US economy is performing strongly and could see further stimulus going forward, Europe faces many headwinds, not least of which are political. As I mentioned a couple of weeks ago, the most critical of these is the French election. Uncertainty over the outcome has already led to a sharp widening of the spread between French and German bonds and a “flight to quality” factor is likely to be partly responsible for the surge in short term German bond prices. There are other reasons including the shortage of repo eligible paper in the euro markets, ongoing ECB buying with an increase in buying of paper that yields below the deposit rate, and the liquidity and collateral needs of European banks. I’m not going to comment on the French elections just now. As we have seen this week, there are many moving parts as the more mainstream players position themselves against Le Pen’s solid 25% support in the opinion polls. I suspect that sentiment will remain volatile until the vote and, unless there is a clear swing in the opinion polls against the Front National, French bond spreads will remain wide and volatile. Keep in mind that the overall yield on French bonds is extremely low – just 0.99% for 10-year maturity. This is not a level of yield to provide much of a risk premium against political uncertainty. Risk aversion will keep those German bond yields extremely negative. More of the German curve could move in the same direction if worries about Greece compound the uncertainties around France.

 

Fixed income, blah… – The drop in German bond yields has impacted on prospective returns in the European credit market. A representative 1-3 year corporate bond index now has a composite yield to maturity of just 0.5 bps. The 3-5 year part of the market yields less than 50 bps and you have to go out beyond 7-year maturities to get a yield of more than 1%. By contrast, 1-3 year US corporate credit yields almost 2%. For European investors wanting higher yielding US fixed income exposure they either have to also take on the foreign exchange risk (a potential decline in the dollar going forward) or accept a lower US yield once the foreign exchange (FX) hedging cost has been taken into consideration. With 1-year hedging costs at close to 2% it makes more sense for European investors looking to the US market to extend their maturity in order to pick up a hedged yield that is superior to that available in the euro market. The returns have diminished as more potential interest rate increases have been priced into the US curve and hedging costs have increased. The difference between 1-year USD Libor and 1-year Euribor has increased by 60 bps over the last year. Still, on a relative basis, the US market is more attractive, especially for those investors with a longer holding period. Nevertheless, for European bond investors that do not want to take currency risk, the choice is very low yields in the high grade market or more risk from investing in the US (higher rates) or in European high yield (credit risk). One of my colleagues suggested that, given the euphoria in equity markets, some investors might be following a bar-bell strategy of cash and stocks and basically cutting out expensive, low yielding European credit.

 

Brexit stopping rates going up? – I’m not sure much should be read into the results of the by-elections in the UK this week, certainly in terms of what the public mood is on Brexit. The problem with a referendum in the context of a parliamentary democracy is that those on the losing side of the plebiscite have very little representation on the result. If you are on the losing side of a general election then at least there is a large body of opposition parliamentarians challenging the government on policy. With Brexit, there is no organized body of opposition that can challenge the government on its implementation of the decision to leave the European Union (EU). Thus is seems that the UK government is heading towards a hard Brexit and that leaves open significant economic uncertainties. These are not all in the same direction. There could be some good and some bad outcomes for the UK economy, but they are massive nonetheless. While the hard data on the UK is solid, the debate about Brexit and its implementation is likely to be a big driver of investor sentiment going forward, especially if there remains no political challenge to the current direction of travel. In terms of UK markets, if it was not for Brexit it would likely be the case that we would be expecting the Bank of England to follow the Federal Reserve and raise interest rates in the months ahead. Inflation is rising, GDP growth is still trending above 2% and even the housing market is remaining buoyant despite cyclical and structural headwinds. That view keeps me with a rather negative stance towards gilts and a modestly positive stance on sterling credit.

 

No bad signs – I participated in an interesting roundtable this week where I was somewhat struck by the consensus view to be underweight fixed income (rates) and overweight equities. There were particularly positive views expressed about European equities given the potential for both earnings and ratings upgrades relative to where the US equity markets are currently valued. At the same time everyone was worried about European politics and “Trump-risk”. Which led to a broader question, one that seems to be being asked in the financial media on most days – what will bring the risk rally to an end? I’ve said it before, in the end the cycle will turn for classic reasons – higher inflation, higher interest rates, increased leverage and slowing top-line growth. It will either be policy induced (the Fed or Trump), or shock-induced (political event). It might not happen for a long time. Indeed, many are now contemplating the cycle being extended to well into the next few years given the presumed flexibility in labour forces (participation rate remains low in the US for example), the ability to automate and the difficulty in reality of rolling back on globalisation. Infrastructure spending could have positive supply side effects. Businesses could only just be starting to ramp-up capital expenditure. When I look at the signals from the bond market it is difficult to identify anything that shouts out short term trouble. Not that much is being priced in in terms of higher interest rates. Break-even inflation rates have risen (and may rise further) but they are well within the range of the last 20-years. Leverage has increased in the US in the corporate sector but not in an immediately dangerous way and liquidity remains very strong (that’s partly why German yields are so low). On the credit side there are no particular signs of negative trends in upgrade/downgrade ratios or any general deterioration in credit quality. So for the moment the bond market – except for a bearish interpretation of German 2-year yields – is not sending any particularly negative signals regarding the risk rally. Valuations are getting richer in credit, that is for sure, but valuations alone are rarely the trigger for a significant change in market trends.

 

Sacked in the morning…  Two people lost their jobs in a high profile way in English football this week. One was the reserve goalkeeper for lowly Sutton United who was caught on TV eating some kind of snack during the match against Arsenal. It turns out that a betting company had offered odds on this happening (in a disrespectful way it has to be said) so he called their bluff and obliged. He was sacked afterwards in a vacuum of humour. The other was Claudio Ranieri who was fired as manager of Leicester City Football Club. Yes, that Leicester City that won the Premier League last May. Sacked in a vacuum of loyalty. I can understand the nervousness about their league position but there are still 13 games to go and Leicester should really stay up, especially on the basis of their second half performance against Sevilla the other night. It’s a harsh game sometimes and one feels for the lack of humanity at times. On a brighter note, United go for what could be the first of three trophies on Sunday afternoon at Wembley Stadium. I learnt never to predict a victory against Southampton in this blog so I will suffice to say that it would be nice. Maybe Rooney will play and score, suggesting that loyalty can still be unearthed on occasion.  

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