Head of Fixed Income Strategy
Summary: More troubles are ahead for European sovereigns and emerging markets bonds as strong economic data underpin the reflation story. On Friday, the nonfarm payrolls exceeded forecasts. Yesterday's data on the US service sector activity spiked to a record high for March. Everything points the economy is heading to a recovery boosting inflation expectations. Thus, a further steepening of the yield curve becomes unavoidable.
(1) The belly of the US yield curve might enter dangerous territory, provoking a deeper selloff in US Treasuries
This week you should pay attention to the belly of the US yield curve as 5-year Treasury yields are dangerously flirting with their 1% resistance level. If they break above this level, they will start to trade in a fast area that could see them accelerating to 1.4% with a weak resistance line at 1.2%. As highlighted previously, 10-year yields are already trading in a fast area. It means that once 5-year yields break above the pivotal 1% level, the selloff in Treasuries has the potential leak in the long part of the yield curve, provoking a squeeze.
The March's Federal Open Market Committee minutes released tomorrow might strengthen bearish sentiment in US Treasuries. It will be necessary to understand whether there is any divergence of forecasts amongst FOMC members. The central bank has revised the economic growth forecasts upward; yet, it continues to embrace the dovish message that interest rates will remain near-zero level until 2023 playing down any rise in inflation this year.
Powell will speak on Thursday at the International Monetary Fund panel on the global economy. It will be interesting to see how he shapes his message in light of a recent IMF report highlighting the risk of a repeat of the 2013 “taper tantrum”. The report notes that if the Federal Reserve, commits a policy mistake, emerging markets would pay it handsomely.
(2) Emerging markets - IMF spring meeting
Expect a lot of talks about the emerging markets this week as the IMF meeting unfolds. As mentioned above, a recent report highlights the risk that if the Federal Reserve unexpectedly signals inflation concerns, it could trigger a selloff in the EMs space. The report calls for "clear central bank communication" to avoid a scenario such as the feared "taper tantrum". We suspect that there is an understanding of how dependent emerging markets have become on debt in the past five years behind the report. Indeed, developing countries have seen lower interest rates in the US as an opportunity to issue cheap US dollar debt, gearing themselves up. Suppose yields continue to rise in the United States, and the US dollar doesn't devalue. In that case, EMs might run into severe refinancing and default risk, which would cut them out from lifeline funds.
We have been vocal about the importance to create a buffer against rising yields in the United States by seeking coupon income. High yield corporate and emerging market bonds can provide such a buffer. When looking at the EMs, local currencies can contribute to the bond's total return by adding currency risk premia. However, let's look at bonds performance in the first quarter of the year (see chart below). On average, bonds across all currencies provided negative returns, except for Chinese renminbi bonds. The problem stems from the fact that a recovery in the EMs will diverge from the one in advanced economies due to vaccination pace. Additionally, developing countries have limited fiscal stimulus potential. Outflows from EM bond ETFs are accelerating as investors realize that emerging market risk rises together with US bond yields and the danger of a "policy surprise" from the Fed. However, the good news that the cheaper EMs bonds are getting, the better opportunity is for investors to pick some of these up. Indeed, economic recovery and higher inflation in the US should positively impact EM debt as soon as the fear of monetary policy mistakes diminishes.
(3) Rotation from European sovereigns to US Treasuries
Countries in the European Union are waking up fast from Easter's lull, realizing that their cost of funding is increasingly rising. It may be the reason why we have a busy sovereign auctions' calendar. Austria, Spain, France and the United Kingdom will issue long term bonds. Among these, the Spanish 20-year and French 30-year bond auctions on Thursday are extremely important. They will provide better insight into investors' appetite for ultra-low yields in the euro area as US Treasuries become more attractive. Just a couple of months ago, France saw record bids (75 billion euros) for the issuance of 7 billion euros of bonds maturing in 2072 (FR0014001NN8). Those bonds have already lost 15% in value, and they look poised to fall even further as it becomes clear that the European Central Bank might not have the tools to slow down the rise in yields. The ECB has been vocal about rising bond purchases under the PEPP. Still, the market is starting to understand that the PEPP has important limitations, such as its capital allocation and the scarcity of Bunds. We believe that things will become worst for the ECB as rotation accelerates and demand for European sovereigns, especially the periphery, will decrease. Tomorrow we will follow up with an in-depth analysis of this issue. Stay tuned!
Economic Calendar:
Monday, April the 5th – Easter Monday
Tuesday, April the 6th
Wednesday, April the 7th
Thursday, April the 8th
Friday, April the 9th
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Chief Investment Strategist
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