Head of Fixed Income Strategy
Summary: As we approach the end of the fiscal year, US Treasuries might benefit from higher investors' demand. However, their long-term bearish trend has been set, leaving yields quite volatile. Federal Reserve speakers, US Treasury auctions, Personal Consumption Expenditures (PCE) can trigger another selloff in the bond market, which could push yields to test their resistance level at 1.75%. While investment-grade corporate bonds registered the biggest quarterly loss since 1981, junk remained stable. However, we believe that once ten-year yields hit 2%, investors might start to dump junk bonds, too, making financial conditions sensibly tighter for weaker companies. In Europe, our focus continues to be on the periphery as their competitiveness is undermined by the rise in yields in the United States.
The selloff in US Treasuries is not over yet. However, we might see some consolidation as corporate pension funds allocate capital into bonds before the end of the fiscal year. The communication problem between the Federal Reserve and the bond market leaves US Treasuries extremely volatile, especially if inflation proves to be on the rise. This is why every economic release, auction and Federal Reserve member’s speech this week can be a catalyst for a deeper selloff in Treasuries. Today Powell will speak at the Bank of International Settlements, and he will testify before Congress on Tuesday and Wednesday. Beyond Powell, there are a dozen other Federal Reserve's members speaking this week, which might give clues regarding their feeling concerning inflation and the bond market turmoil.
The market struggles to agree with the Fed's dot plot, which doesn’t see interest rates hikes until 2023. Hence, it takes monetary policy into its hands by dumping Treasuries. The central bank's problem is that if nominal yields rise too much, they might hinder the negative interest rates policy that the Federal Reserve has been committed to since January last year, forcing the Fed’s hand to cap long term yields.
In terms of technical analysis, 10-year Treasuries are trading in a fast area, meaning that either they continue to rise towards 2% or they might test their support line at 1.65%. Bearish and bullish sentiment can arise from any Federal Reserve speaker, Treasury bond auctions and inflation data. The US Treasury will issue 2- and 3-year notes during the next couple of days, but it will be on Thursday that the focus will turn on the 7-year note auction which last month attracted the lowest demand since 2009, with foreign investors’ bids plunging the most since 2014. A repeat of the same could spark even a deeper selloff, with yields rising fast towards the very pivotal level of 2%. This time around, demand could be supported by corporate pension funds allocating capital into bonds before the end of the fiscal year, especially now that US Treasuries offer a more competitive yield than other sovereigns (to learn more, click here).
It’s crucial to understand that although we might be facing a better week for US Treasuries, the bearish trend has been set, and the bond market will continue to be volatile, putting at stake risky assets. It’s nearly impossible to make forecasts about where yields will end up by the end of this year because there is the risk that if the Federal Reserve continues to dismiss the bond market, nominal yields could spike together with inflation expectations provoking serious disruptions.
If the duration event that we are witnessing now intensifies, it can easily pose funding hurdles that the market will pay handsomely. This quarter, US investment-grade credits fell the most since 1981. Their historically high average duration made them more vulnerable to a rise in interest rates than junk bonds. The primary market has been forced to reduce the average maturity of new issuances this quarter pointing to the fact that capital structure is changing profoundly among those sectors that are characterized by above-average duration, such as utilities, telecommunications and technology. If interest rates continue to rise, there is the risk that the junk credit space will be the next victim. Indeed, many high yield corporate bonds rely on the low cost of funding and a stable market.
The European bond market will continue to focus on US Treasuries this week while more countries are extending and imposing stricter lockdown rules. Germany’s Ifo survey will tell whether business expectations continue to rise or if new lockdown measures start to scare the market. However, the biggest problem in Europe remains the rise in yields in the United States, which are becoming more and more convenient compared to the periphery once hedged against the EUR. Indeed, the US safe-havens offers around 0.85% in yield once hedged against the euro, around the same yield offered by Greece (for more, click here).
This point should be extremely concerning for the ECB because it could trigger another selloff in the periphery, such as the European sovereign crisis. Greek bonds are more at risk of rotation as they are rated junk and mainly held by foreign investors. However, a selloff in Greek sovereigns might leak easily to other countries to the periphery, such as Portugal, which debt is also held largely by foreigners.
In the United Kingdom, data releases will focus on inflation, retail sales, flash PMIs and labour data being released throughout the week. So far, the Bank of England seems to be looking towards the Federal Reserve's same direction anticipating inflation to hit 2% this year as the economy recovers fast amid an efficient vaccination program. The BOE last week said it is committed to keeping rates on hold until the inflation target will be achieved sustainably. Yet the central bank didn't sound concerned regarding the fast rise in Gilt yields, which rose even more exponentially than those of the Treasuries since the beginning of the year. Ten-year Gilts are trading around a resistance level of 0.85%; however, there is the risk that once they break this level, they will rise fast towards 1%, where we believe the BOE will need to pay more attention to their rise as they might start tightening financial conditions.
Economic calendar
Monday, March the 22nd
Tuesday, March the 23rd
Wednesday, March the 24th
Thursday, March the 25th
Friday, March the 26th
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Chief Investment Strategist
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