A decade of central bank intervention, which has included low interest rates and bond-buying programmes across the developed markets, has resulted not only in a sharp rise in equity markets post-the financial crisis, but also in extreme valuations in both the credit and sovereign developed markets. Indeed, G7 sovereign yields are at historic lows, while spreads in corporate bonds appear to be considerably stretched, back at pre-crisis levels. Additionally, an important bi-product of the central bank intervention is the significantly low levels of volatility exhibited by the financial markets. Indeed, in spite of the event and political risks that have been omnipresent (Brexit, North Korea and uncertainty surrounding the Trump administration, to name but a few), volatility levels have, in fact, reached record lows. However, this previously colossal and unequivocal central bank support is now being withdrawn, ushering in a new era in the debt markets.
Investors have almost gotten used to the longstanding and previously much-needed accommodative central bank stance, which, in times of crisis, has acted as a life-support for the markets. The crucial question now asked is, once the support is withdrawn, will the bond markets be headed for the much dreaded crash?
The current inflationary environment, however, appears weak and is struggling to reach the 2% targets that central banks have established. The issue appears to be structural, as the positive output gap in the US and absence of wage inflation suggest long-term disinflationary pressures. Furthermore, central banks appear to be committed to a gradual lowering of their accommodative stance, with the ECB being ever so cautious in its tapering of the QE programme (which should continue at least into September 2018). The new Fed chair nominee Jerome Powell is a proponent of cautious rate hikes, though his ability to generate consensus à la Yellen in a committee that will see four new members remains to be seen. What is striking, though, is that the decline of monetary support is increasingly likely to force investors to focus on fundamental issues, and specific risks/idiosyncratic factors are going to come to the forefront as major drivers of the fixed income markets.
Tactical exposure to Treasuries, Short Duration on EUR Core Sovereigns
The current expansionary cycle in the US is already amongst the three longest in history post-WWII and will be boosted by the fiscal plan that should be voted on shortly. The full potential effects of the measures are still unclear, as lawmakers continue to negotiate the reforms in both houses of the US congress. In the meantime, the market appears to be pricing in only a single rate hike for 2018, while the Federal Reserve has indicated three probable hikes. This is likely to lead to an increased flattening of the US curve (as the short end rises more than the long end). It would be important to monitor the events surrounding the tax reform bill as the passing of this major piece of legislation could signal a shift in inflation and growth. Hence a tactical approach to the US markets is increasingly appropriate as political uncertainty clouds the macro-economic outlook.
Europe, on the other hand, has seen political risk decline over the course of 2017, with the election of pro-Europe parties in the Netherlands and France. More recently, the Eurozone demonstrated a united front in the face of the separatists in Catalonia, while, in Germany, Angela Merkel should continue to stay in charge with some form of coalition government. More importantly, growth has returned to the single market and is more broad-based while inflation appears to be gradually ticking upwards. On the back of these events, the ECB has lowered its quantitative easing programme to 30 billion/month, which will last till September 2018. Following that, we expect additional tapering and the end of the asset purchase programme in December 2018. Subsequently, the first rate hike could occur in the 4th quarter of 2019. This context is likely to put upward pressure on core rates, which are already at extremely stretched valuations, thereby justifying an underweight/short position on core Eurozone sovereign rates, which we estimate will reach 0.90% over the next year. Elsewhere on the continent, peripheral sovereign bonds are benefiting from a better fundamental picture, and valuations – still relatively attractive – could be an interesting source of carry in the context of the presence of the ECB backstop (albeit with a lower amplitude).