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March 2017
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Don’t bank
on (all) bonds
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For professional clients and qualified investors only
All quiet on the fixed income front...for now
After a 30-year bull market, fixed income investors are now staring down the barrel: 2017 could
be the year the government bond bubble finally bursts. It’s no time to be blithely banking on
bonds. Jeanne Asseraf-Bitton, Lyxor’s Head of Cross Asset Research, tells us more.
Executive Summary
►► Bondholders are staring down the barrel. Too many factors collide in 2017 for it to be anything
other than the year the government bond bubble finally bursts
►► An early flight to quality will be undone by developed world governments and their switch
to fiscal, rather than monetary, policy
►► Massive infrastructure spending and tax cuts will bring the era of deflation and stagnation
to a close
►► Troubles start in the US, where full employment and mounting wage pressure are
fuelling reflation
Jeanne
Asseraf-Bitton
Head of Lyxor
Cross Asset
Research
►► Brexit and possible ECB progress towards the QE exit door could fan the flames
The end of an era
President Trump’s efforts to ignite the US economy through massive infrastructure
spending and tax cuts could herald the end of the era of secular stagnation and
deflation. His fiscal push could force headline rates higher than many expect.
And yet it remains quiet, possibly too quiet in the bond markets. Although higher, current
US Treasury yields – as at 16 March they were around 2.52%* – suggest people are still
expecting the kind of monetary policies that have suppressed yields since the Global
Financial Crisis to persist. In our view, they also suggest President Trump’s economic
measures will fail. Neither looks likely to us.
In fact, most macroeconomic indicators are already suggesting activity is improving, even though
most of the big-ticket reforms are yet to materialise. We expect the US economy to grow by
around 2.5% this year, slightly above consensus estimates. A slight caveat – there are some
bearish signals too.
*Source: Bloomberg, Lyxor CAR. Data as at 16 March 2017
Risks on the rise: Our US yield calls
ff 50% chance 10-yr yields hit 3%+ by year end
Factoring in consensus growth and inflation assumptions of 2.3% and 1.9% respectively, reasoning
through the yield curve and adding in funding rates at 1.5% we find US Treasury yields should hit
3.2%. Any renewed debt ceiling brinkmanship could render this forecast too low.
ff 40% chance 10-yr yields hit 4%+ by year end
We think those growth and inflation forecasts could be too conservative. Replace those numbers
with ours (2.5% and 2%), and yields could hit 4%. Monetary policy would end up some way behind
the curve.
ff 10% chance 10-yr yields drop to 1.5% by year end
This is worst case scenario territory for Trump’s push. Should the macro dynamics falter, the Fed
tighten too eagerly or geopolitical tensions flare yields could plunge to their historical lows near 1.5%.
Contact us
+44 (0) 800 707 69 56 | [email protected] | www.lyxoretf.co.uk
It’s no time to be
blithely banking
on bonds
Lyxor ETF – Don’t bank on (all) bonds
2
Feeling contagious?
If the US sneezes, the rest of the world catches a cold, or so the saying goes. And historically, US
Treasuries and G9 government bond yields do tend to move in tandem when bonds are selling off.
We’ve seen plenty of that since Trump’s victory, to the extent it’s now “just” one-third of the bond
market in Europe that yields less than zero, from around half in early November.
Bonds: fairly valued or fair game?
Portugal
Canada
Spain
Italy
France
Netherlands
US
Germany
Switzerland
5 Yr Average
Current Yield
UK
(1)
0
1
2
3
4
5
Source: Bloomberg, Lyxor ETF. 10-yr government bond yield data as at 21 March 2017.
Many in the market have assumed the sell-off went too far, too fast. In our view
those investors are yet to adjust to the new economic and policy reality.
Trump trade fades
It’s true the Trump trade faded as political risk mounted, but the factors that
initially underpinned it - solid growth and inflation news, fading monetary
support – were only momentarily obscured.
Some investors are
yet to adjust to the
new economic and
policy reality
Policies are changing almost daily in the US, so further sell-offs can’t be ruled
out. The Fed has however learned its lessons. The 0.25% hike in March was
signalled loud and clear some way out, so its immediate impacts on the markets were limited. Much
depended instead on the path ahead. By sticking to its expected normalisation path – five hikes
between now and the end of 2018 - the Fed signalled it intends to stay “behind the curve” to help
growth momentum build up. In contrast, the Taylor rule already recommends the Fed Funds rate
should be around 3.5-4%.
Whether it can even join those dots in a world so leveraged to the dollar, and so sensitive to US
borrowing costs, remains to be seen. The Fed may have to be the world’s central bank for a while yet.
Calm, or complacency? How major bond markets have moved since Trump’s triumph
3.0
UK
US
Germany
2.5
2.0
1.5
1.0
0.5
0.0
08-Nov-2016
04-Dec-2016
30-Dec-2016
26-Jan-2017
Source: Bloomberg, Lyxor ETF Research, 10Yr Government bond yields, March 2017.
Contact us
+44 (0) 800 707 69 56 | [email protected] | www.lyxoretf.co.uk
21-Feb-2017
20-Mar-2017
Lyxor ETF – Don’t bank on (all) bonds
3
Europe in the firing line
Eurozone valuations still look rich, especially in core markets like Germany where the share of
negative yielding debt remains over 50%. Much depends on whether Draghi and his doves can
resist the taper temptation. Any action before 2018 would, in our view, be a mistake but investors
do need to prepare for ECB life support to be turned off.
If the bank were to taper this year – some observers are predicting a EUR
20 billion cut in its Public Sector Purchase Programme in September –
things could get worse for fixed income investors as such a cut is not
being priced in. Rate rises still look a more distant prospect, despite recent
speculation.
Much depends on
whether Draghi and
his doves can resist
taper temptation
For now, ECB support and political risk have kept a lid on yields. The
Dutch election result soothed some nerves, and prompted a relief rally in
equities in particular. We expect “risk on” for a while yet, but the risk premia
being priced into EMU bonds are more deeply engrained. All eyes are on
France – the key battleground in Europe once again.
In our view, investors should tread, and trade, carefully amid political uncertainty and what are
likely to be more volatile country spreads. A prudent approach to duration may also be warranted.
Favour the core
We’d also err on the side of caution when it comes to exposures to peripheral euro sovereign
debt should bond yields rise generally and ECB support fade. Uncertainty in Italy, whether in
its financial sector or its chaotic political scene, won’t go away any time soon. And there may
be more stress from Greece, especially if IMF commitments are pared back further – which is
possible should Trump start questioning why the institution spends so much of its resources on
Europe. Favour the core, and play the politics, not the economics.
When politics matters more than policy: Eurozone 10-yr spreads over bunds
Brexit Shock!
Trump Triumph!
Far right not so far
fetched in Europe!
240
180
120
60
0
03-Jun-2016
30-Jul-2016
France
25-Sep-2016
Spain
22-Nov-2016
Netherlands
18-Jan-2017
17-Mar-2017
Italy
Source: Bloomberg, Lyxor ETF Research, Eurozone 10Yr Government bond yield spreads over bunds, March 2017
Brexit battles
Brexit could also play a part in bringing to an end the bond party. The prospects of a “hard” Brexit
continue to keep sterling depressed, and will eventually feed through to higher prices, leading to
rising inflationary pressure. With no more Bank of England easing in sight and the latest tranche
of quantitative easing coming to an end, the outlook for conventional UK gilts is neutral at best.
Contact us
+44 (0) 800 707 69 56 | [email protected] | www.lyxoretf.co.uk
Lyxor ETF – Don’t bank on (all) bonds
4
Know your credit limit
After a good 2016 for credit, it’s difficult to be too optimistic this year. Spreads will widen as general bond yields rise. In fact, if
spreads properly reflected political risk, they’d already be much wider than they are now.
The next few months could be difficult for European credit investors if political risk is as badly mispriced as we fear, although
the ECB’s corporate sector purchase programme does provide some support. But other assets look likelier to be hit first
should the ECB taper. Healthy corporate fundamentals, a low default rate and a more robust banking sector also provide some
respite.
After the party
So what should investors do if the peace in the bond markets is finally shattered? Put simply, it’s about using all of the tools at
their disposal.
Tactical trading may be important with bouts of volatility rocking today’s relatively illiquid fixed income universe. Hedging with
linkers, breakevens and floating-rate notes could help as reflation kicks in and rates start rising. Look to short-dated or highyield bonds to reduce rate sensitivity, and use shorts to protect against, or exploit, downturns.
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