Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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Fixed income market: the week ahead
Althea Spinozzi
Head of Fixed Income Strategy
Summary: This week, there is the risk that Treasury yields will continue to rise as Federal Reserve's speakers might expand on the tapering comments in the FOMC minutes last week. Suppose a Democratic Congress has pushed tapering expectations forward. In that case, Treasury yields will rise faster than expected trying as early as this week their resistance level at 1.20%. As bond yields rise in the U.S., more pressure is applied on emerging market bonds as E.M. borrowers' cost of funding increases bearing an elevated refinancing risk. In Europe, it is crucial to understand whether more stimulus is coming from the ECB as a new strain of Covid-19 virus is leading to stricter lockdown measures. This Thursday, the European Central Bank's minutes will be crucial in understanding whether the ECB is prepared to do more to support the bloc's economy. Any discussion concerning more stimulus would translate in an upside for the periphery. In the U.K., Bank of England's speakers might expand on negative interest rates, underpinning a rise Gilts.
This week may prove to be hectic for bond traders. After 10-year yields broke the pivotal 1% level last week as Democrats secured the majority in the Senate, yields continued to rise. Treasury yields closed the week on the upper resistance line of the trend channel they have been trading in since August. If they break above this level, they will trigger a selloff that could push them to try the next resistance line at 1.2%.
This week, the focus will be on Federal Reserve speakers as the market is still trying to digest December's FOMC minutes released last week. The report showed that although there is no intention to alter the bond-buying purchasing program, tapering is starting to be discussed. At this point, any mention to tapering cannot be ignored, mainly because things have profoundly changed since Democrats secured the Senate furthering the reflation story. In a speech last week, Fed's Raphael Bostic said that if the U.S. economy gets strong, the central bank might taper earlier than expected. Bostic is speaking twice this week: today and on Thursday. For bond investors, it is crucial to understand whether the Fed could envision earlier tapering. It is enough for tapering expectations to be moved forward to 2022 for the market to continue to sell off and the U.S. yield curve to bear-steepen.
We see more downside for Treasuries across the yield curve at this point of time. Firstly, real yields are deeply negative meaning that investors are losing money by holding nominal Treasuries. Secondly, low yields are causing Treasuries to be highly price-sensitive, especially for long durations. In just five trading days, 10-Treasury yields moved up by about 20 basis points, representing a loss of around 2% for bondholders. Thirty-year Treasury yields moved up by 23bps inflicting a loss of 5% on bondholders.
While there is a large room for downside, any upside is limited as the Fed is unquestionably not looking to cut the benchmark interest rate below zero. Hence, we remain underweight ETFs exposed to long-duration such as the iShares USD Treasury Bond 20+yr UCITS ETF (TLT) and the iShares Barclays 10-20 Year Treasury Bond Fund (TLH). At the same time, we continue to favour inflation-linkers such as the PIMCO 15+ Year US TIPS Index (LTPZ) and PIMCO Broad U.S. TIPS Index Fund (TIPZ).
As Treasury yields continue to rise in the U.S., emerging market debt starts to sound the alarm bells. Although on one side a weaker dollar benefits E.M. debtors as they can service their debt cheaper, on the other their cost of funding is rising making them vulnerable to refinancing risk and defaults if they rely on external financing. Last week, U.S. dollar-denominated bonds from Indonesia, Peru, Mexico, Turkey and Brazil widened on average by 15 basis points. Brazil led the group widening by 20bps as Bolsonaro said that the country was “broken” indicating that it may need to raise expenditures. Even though we are cautious on E.M. government debt as U.S. yields are rising, we believe that emerging market corporates remain a reliable source of coupon income to protect against negative real yields. However, it is indispensable to limit duration exposure. Among EM corporates, energy companies remain our favourite, especially as commodity prices are recovering. In case you look for opportunities within this space, refer to the analysis here.
In Europe, the focus will be on the ECB's minutes from December as more stimulus might be needed in light of new lockdown measures to slow down Covid-19 cases and hospitalizations. In case the ECB has discussed more stimulus to underpin the bloc's economy, we might see the periphery rising. Contrary to what we see in the U.S., bonds with long duration will benefit the most from more stimulus, representing an upside for ETFs such as the Xtrackers II Eurozone Government Bond 25+ (DBXG).
In the U.K. watch out for Bank of England's speakers. Last week when testifying with the Treasury Select Committee, Governor Bailey said that the economic downturn of the last quarter of 2020 wasn't as bad as they initially had forecasted. However, he made sure to say that negative rates continue to be an essential tool in the box. Today, Gilts may rise as BOE's Silvana Tenreyro, one of the biggest advocates for negative interest rates, is speaking. Since early December ten-year Gilt yields have started to trade in a descending trend line, which may lead them to test 0.1% in case the BOE cuts interest rates negative. Economic Calendar
Monday, January the 11th
- Australia: Retail Sales
- China: Consumer Price Index
- Spain: Industrial Output
- Eurozone: Sentix Investor Confidence
- England: BOE’s Tenreyro speech, BOE’s Governor Bailey speech
- Canada: Bank of Canada Business Outlook Survey
- United States: 3- and 6-Months Bill and 3-Year Note Auction, Fed’s Bostic speech
- Japan: Current Account and Trade Balance
Tuesday, January the 12th
- United Kingdom: Like-For-Like Retail Sales, BOE’s Broadbent speech
- Italy: Retail Sales
- United States: NFIB Business Optimism Index, Redbook Index, Fed’s Brainard and Rosengren speech, 10-Year Note Auction
Wednesday, January the 13th
- China: Foreign Direct Investment
- Italy: Industrial Output
- Eurozone: Industrial Production, ECB’s Lagarde Speech
- United States: Consumer Price Index, Fed’s Brainard and Clarida speech, 30-Year Bond Auction, Fed’s Beige book
Thursday, January the 14th
- China: Trade Balance
- Germany: Real GDP
- Eurozone: ECB Minutes for December
- United States: Initial Jobless Claims, Fed’s Chair Powell speech, Fed’s Bostic speech
Friday, January the 15th
- United Kingdom: Trade Balance, Manufacturing and Industrial Production, Gross Domestic Product for November, National Institute of Economic and Social Research GCP Estimate
- Eurozone: Trade Balance
- United States: Retail Sales, Michigan Consumer Sentiment Index
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