27 APR


Fixed Income , Topics

Inflation-linked bonds continue to be a favourite; US the preferred market

The inflation stage continues to be well anchored in the G4 cycle and recent months have seen a marked acceleration, supported by sharp up-ticks, especially in the eurozone. In the US, the pick-up has been supported by wage and consumer components that have contributed substantially to the uplift. Furthermore, the expectation indicators have turned positive, strengthening the US inflationary rebound. After such a strong rebound, it will be vital to gauge momentum in the coming months as some stagnation is likely, especially since the “Trump Trade” is waning. Indeed, the new budget, tax reforms and other previously expected measures appear to lag the expectations that have been built in. The eurozone, on the other hand, is well inside inflation territory, a trend now turning more homogeneous amongst sub-indicators. While expectations remain low, the recent acceleration is impressive (as our indicator is now above its long-term average). Additionally, higher inflation is very much present in other regions, with Britain benefiting from a lower Pound sterling and the Japanese disinflationary trend appearing to have bottomed. Other developed countries are also feeling the inflationary effects of an ultra-low rate policy, with countries like Sweden experiencing reflation.

Similar to the inflationary phase, the activity cycle continues to experience economic expansion in the G4, though the eurozone appears to be losing some traction. The US continues lead the expansionary phenomenon, with probabilities clearly identifying an expansionary stage, although it will be important to monitor this in the coming months as there remains a large difference between soft and hard data. Furthermore, an important portion of the priced-in growth expectations have been based on the fiscal policies proposed by the Trump administration, which appear to be increasingly tough to push through. The UK, on the other hand, continues to stabilize and the declaration of a snap election by Theresa May will further add to the uncertainties surrounding Brexit, which appears to be finally catching up. In the eurozone, while economic momentum continues to build, the activity cycle appears to have peaked at a new 4-year high and some downward movement can be expected.

In light of the current context, some further normalisation of monetary policies is expected in 2017. The Federal Reserve hiked rates in March and two additional hikes are anticipated. Chair Yellen also spoke of normalising the Fed balance sheet by ending the reinvestments built into the current programme. This could also be interpreted as a “safeguard” by the Fed, which could be a means of reducing monetary support so as to have some “easing ammunition” in the arsenal in case of a significant downturn. Broadly speaking, the reflationary trend is going to be a challenge for central banks, all the more so as excessive accommodative policies are producing undesired effects.

In terms of the debt cycle, fundamentals point towards a bullish consolidation, as the business cycle is in the expansion phase, while the credit cycle appears to be in a downturn phase. This is a material change from recent months, when the G4 region appeared to be in a credit boom, with expansion on both activity and debt cycles.

Global Rates Strategy

Sovereign bonds in general saw a good performance over the course of March, with US treasuries among the leading performers. After their recent mixed results, US 10-year rates have sharply compressed since mid-March, with the markets appearing to favour safe havens. In the eurozone, performance was positive overall, with peripheral sovereigns outperforming core rates (which actually performed well themselves). Even French sovereigns generated decent returns (albeit amongst the lowest), in spite of the looming political risk brought on by the upcoming elections. Also, in spite of this climate of increased political anxiety, Portugal, Spain and Italy led the way with strong returns. Developed markets were not the sole beneficiaries of the recent rally, as both EM local and hard currency markets delivered a strong positive performance in the wake of the rise in other risk-on assets.


Inflation-linked bonds continue to be a favourite; US the preferred market

We continue to believe that there remains a reasonable gap between what has been priced in by the market and current/ expected inflation levels. Break-even protection levels are positive in the US and this, combined with an inflation cycle that continues to point upwards, leads us to maintain our positive view on US break-evens. However, our momentum indicator appears to be weakening and, having already witnessed a strong rebound in inflation, we remain wary of the lull in the Trump reflationary trade that could affect the linkers markets. Hence, in spite of an overall positive picture, we are taking profits on our break-even positions in the US. In Europe, break-even protection now appears to be at interesting levels, and the momentum indicator (supported by the monetary cycle) has turned positive. Hence, on the back of these elements and an improved carry, we aim to add to our European break-even exposure. We are, of course, keeping an eye on the ongoing elections in France but note that virtually all the front runners present a favourable picture for inflation. A source of diversification is our favourable view on Australian break-evens, which is supported by an inflation cycle that is finally rebounding after having bottomed out. Probabilities of reflation are also higher than before and the Australian break-even spread with the US is at a 5-year low.

Tactically managing exposure to US rates

The base-case scenario continues to point towards rising rates in the US (on the back of better activity and and an improved inflation cycle) and US treasury yields have already seen an increase in recent months. It seems, however, that there is an increasingly large difference between hard and soft data, calling into question the momentum of the inflation and activity cycle. As the market is also witnessing disappointment over the expected measures that President Trump was supposed to push through, the reflationary sentiment appears to be temporarily fading. Finally, we have noticed that the level of short positions on the mid-to-long-end segment of the US curve is now decreasing, as investors seem to be unwinding the trade. This context, combined with clearly increasing political risks, leads us to tactically hold a long exposure to US rates.

Short position on 10-30 year portion of EUR curve

The ECB’s expansionary monetary policy is supportive of non-core European yields, as are the supply & demand dynamics. However, in the face of improving inflation numbers as well as the macro-economic outlook, there appears to be some concern regarding the ECB’s future policies. Additionally, there is a growing discussion and debate around the probable tapering of the current QE programme, which could call into question the accommodative stance of the central bank in 2017. Furthermore, core markets in the eurozone are expensive, with rates at extremely low levels. Added to this, the first round of the French presidential election took place, with the new centrist candidate Emmanuel Macron and Far-right leader Marine Le Pen qualifying for the second round. Markets should be relieved as a battle of extremes (far-left vs. far-right) has been avoided. Furthermore, based on party leader recommendations and calls to vote, it would appear that Emmanuel Macron (the market friendly, pro-Europe candidate) is firmly in the driver’s seat, and dominating recent 2nd round polls. In this context, investors might no longer focus on safe havens, and EU core rates (especially German ones) are likely to rise. There are some core rates on which we hold a positive view, namely Belgium, where supply & demand dynamics are supportive and valuations relatively favourable.

Our stance on non-core sovereigns in the eurozone is growing more positive while investor positioning continues to lighten on the segment. We are keeping a prudent stance on Portugal while being more tactically favourable on Italy and Spain, on the back of a good TLTRO pick-up and waning political risk in those countries. 

Currency Strategy

Over the course of the past month, the Yen (JPY. +5.07%) rose quite significantly as investors have favoured safe havens since mid-March. The surge in the Mexican peso (MXN, +4.80%) continued, with a sharp upward correction propelling it to the status of best performer since the beginning of the year after several months of negative returns. Certain EM currencies saw a good performance overall, with the Thai Baht (THB, +2.6%), Indian Rupee (INR, +2.80%) and Chilean Peso (CLP, 2.2%) leading the way. The USDhad a good run in February and that trend flattened as the greenback managed a meagere0.3% vs. the EUR in March. On the other hand, the South African Range (ZAR, -4.20%) suffered considerably on the back of the political turmoil witnessed in the country that included the sacking of the finance minister and downgrading of the country’s credit status (by Fitch) to “junk”.

Negative framework for USD while JPY remains a safe haven

Though long-term indicators continue to point towards an expensive US Dollar, the carry and investor positioning are supporting the currency. Additionally, supply/demand dynamics remain tight, and could drive the greenback higher over the short term. However, the post-election question of whether new president Donald Trump would allow the dollar to strengthen is coming into focus. Since taking power, Mr. Trump has taken a tough stance towards countries running high trade deficits with the US (Japan, Mexico, Germany), and recent comments clearly signal Trump’s eagerness to limit USD strength.

Though rate differentials remain penalizing, our indicators (PPP, Trade and capital flows) show the Yen as apparently attractive. And, in the current environment of geo-political uncertainty and the heavy dose of event risk present, the Yen still remains an attractive safe haven and diversifying asset.

Overweight higher-yielding Emerging FX vs. underweight low-yielding Asian currencies

EM FX has rebounded YTD on accelerating EM growth recovery and expectations of reflationary US policy bias. We expect this trend to continue, notwithstanding some volatility around Fed Funds hikes.

We have a small short position in USD, with overweights (OW) in higher-beta/higher-yielding currencies such as the Brazilian Real (BRL), the Colombian peso (COP), the Indonesian Rupiah (IDR) and the Mexican Peso (MXN), and an underweight (UW) in the CNH.

Our continued overweight stance in the COP and the BRL are justified by our expectations of commodity FX outperforming the broader EMFX universe, by the strong external/FX Reserve position of Brazil and the stable macroeconomic fundamentals for Colombia.

We hold a tactical overweight on the Mexican peso (MXN) as it offers an attractive long-term valuation and could benefit from recovery after the sharp decline that followed the US presidential election. We also like the credible Banxico policy management process (introduction of an FX swap programme and application for a Fed swap line).

We are maintaining our structural underweight on Asian currencies. The Chinese Yuan (CNH) is expected to continue depreciating in the medium term due to the liberalization of its capital account and its slower growth.