Fixed income market: the week ahead

Japanese investors’ convenience to buy into US Treasuries has been growing exponentially since the beginning of the year. Indeed, 10-year US Treasuries hedged with a 3-months forward against the Japanese yen offer a yield of roughly 1.22%, the highest since 2015. Yet, if one wants to hedge its FX exposure against JPY fully, their yield would fall to -0.21%. Only when US Treasury nominal yields hit 2% they would provide a yield equal to that of 10-year Japanese Government Bonds (JGB). That's why we believe that 2% in 10-year US Treasuries is a much stronger resistance level than 1.75%. Suppose the macroeconomic backdrop continues to strengthen, exacerbating inflation. In that case, the only way for 10-year US Treasury yields is to rise and try 2%. Until then, everything that is happening in the market is just noise.

(2) PBoC to hold rates steady as financial risk looms

We expect the PBoc to keep its Loan Prime Rate (LPR) unchanged at tomorrow’s interest rate decision. The focus will be again on balancing support to the economic growth and prevent financial risk. The latter is an increasingly important point amid the Huarong panic, which forced China's financial regulator on Friday to comment on the bad-debt manager financial conditions to put a stop to the rout. The central bank is also expected to expand stress testing to 4,024 banks this year, in contrast with 1,550 institutions tested in 2020. We see these actions as favourable to bond investors looking to take on Chinese credit risk. The PBoC is prioritizing financial stability by providing support and deleveraging the system.

Nevertheless, it's crucial bondholders remain cautious as corporate bond defaults are gaining momentum. This year, $16.7 billion of onshore and offshore debt has defaulted in only three months, which is already around half of the total corporate defaults of 2020 ($29.4 billion) and 2019 ($25.8 billion). Additionally, according to Bloomberg calculations, it has become more difficult for Chinese corporates to roll over debt.

(3) The European Central Bank cannot disappoint

On Thursday, the European Central Bank meeting will be in the spotlight as the central bank didn't deliver yet on the promise to control rising yields in the euro area. Strategists from the street are warning of “taper tantrum” risk within European sovereign bonds this week. They believe that if the ECB doesn’t sound dovish enough, yields will need to catch up with stronger economic expectations and faster vaccine roll-outs.

We share their view that there is no upside in holding European sovereigns currently. Nevertheless, we believe that the ECB will do its utmost to sound dovish at Thursday’s meeting because deflation risk remains the biggest concern in the euro area despite its improving macroeconomic backdrop. Let's compare the USD Inflation Swap Zero-Coupon rate curve with the EUR Inflation Swap Zero Coupon's one (chart below). We notice that inflation expectations in the euro area are entirely different from those in the US. The inverted Inflation Swap Zero-Coupon in the US tells us that inflation is due to a spike in the short term and normalize in the long term. In the case of Europe, inflation will slowly rise, yet missing the ECB target rate of 2%. Thus, the central bank must keep monetary conditions extremely accommodative to ensure that an economic recovery will revive inflation in the long term. Within this context, the ECB cannot tolerate a further rise of yields in the euro area because they have the potential to tighten financial conditions.

Last week alone, we have seen Portuguese 10-year government bond yields rising ten basis points to 0.42%. Although it isn't widely covered news, there is increasing concern that bad loan risk rises within Portugal's banking system. According to a recent interview, Fitch estimates that up to 10% of loans currently under moratoria could go bad as moratoria and other support schemes loosen up. At the same time. Last week Bank of Portugal's report shows that the ECB financing to Portuguese lenders rose in march to the highest since 2014. The Central Bank's financing of Portuguese banks peaked in June 2012 while the European sovereign crisis was unravelling and Portuguese 10-year government bonds were paying still well above 11% in yields. It adds to the rotation risk from European sovereigns to the US safe havens we have discussed in a previous analysis.

Economic Calendar:

Monday, April the 19^th

• Japan: Merchandise Trade Balance, Imports and Exports, Industrial Production
• Australia: HIA New Home Sales
• Eurozone: Current Account, Construction Output
• Germany: Bundesbank Monthly Report

Tuesday, April the 20^th

• China: PBoC Interest Rate Decision
• Australia: RBA Meeting Minutes
• United Kingdom: Claimant Count Change, ILO Unemployment Rate, Average Earnings
• Germany: Producer Price Index
• Eurozone: ECB Bank Lending Survey
• United States: Redbook Index

Wednesday, April the 21^st

• New Zealand: Consumer Price Index
• Australia: Westpac Leading Index, Retail Sales
• Russia: Central Bank of Russia Key rate decision
• United Kingdom: Consumer Price Index, Retail Price Index, PPI Core output, BoE’s Ramsden speech, BOE’s Governor Bailey speech, UK to sell 2035 Gilts
• Germany: 10-year Bond Auction
• Canada:Consumer Price Index, BoC Rate Statement, BoC Monetary Policy Report, BoC Interest Rate Decision
• United states: 20-year Bond Auction

Thursday, April the 22^nd

• Australia:National Australia Bank’s Business confidence
• Spain: 3-, 7- and 10-year Bond Auction
• France: 3-, 5- and 7-year Bond Auction
• Eurozone: ECB Interest Rate Decision, ECB Policy Statement and Press Conference, Consumer Confidence
• United States: Existing-home Sales, Kansas Fed Manufacturing Activity

Friday, April the 23^rd

• Japan: National Consumer Price Index
• United Kingdom: Retail Sales, Markit Manufacturing and Services PMI, Markit PMI Composite
• France: Markit Manufacturing and Services PMI, Markit PMI Composite, Consumer Confidence
• Germany: Markit Manufacturing and Services PMI, Markit PMI Composite
• Eurozone: Markit Manufacturing and Services PMI, Markit PMI Composite
• United States: Markit Manufacturing and Services PMI, Markit PMI Composite, New Home Sales