Fixed income outlook: Just another range trade

Well, this has been an unusual year. The UK recorded its worst economic performance in over 300 years, many economies experienced the biggest rise in government debt since World War II, we had negative spot oil prices and experienced a faster credit market sell-off than in 1929. And yet, many global aggregate fixed income markets – remarkably – enter December 2020 at levels similar to where they began the year. US investment grade (IG) credit spreads are only +6bps wider than their 1 January level, despite having been 300bps wider at one point. Swiss 10-year government bond yields are a mere 4bps lower, while 10-year JGB yields are just 4bps higher. In Asia, South Korean and Chinese 10-year yields are almost unchanged versus a year ago. Spanish bond spreads to Bunds are just a fraction tighter and the Bund curve itself is right back where it was fourteen months ago. Currencies as diverse as the Malaysian ringgit, the British pound sterling and the Chilean peso are almost exactly back at the same spot levels as 12 months ago. For sure, the US Treasury yield curve has bull steepened significantly – as we expected and wrote this time last year. BTP spreads are also meaningfully tighter. Yet in many other respects, 2020 has just been a giant range trade.

Faced with yields of just 0.30% in EUR investment grade as recently as ten months ago, it has been possible to generate meaningful high single-digit total returns in the interim, albeit with a very active approach to fixed income asset allocation. Maybe ranges aren’t so bad.

2021 may, in many respects, be just another range trade. Granted, it is a high (and improbable) bar to expect the same degree of intra-year spread volatility. But within likely smaller market ranges all round, we would not be surprised if, for instance, 2-year Treasury yields – indeed 2-year yields in almost all DM markets – were little changed from current levels. At the other end of the spectrum, 30-year JGB curves may also be close to unchanged. If the secular prospect of Japanification – so prevalent a theme pre-Covid-19 – is remembered once again after the current vaccine euphoria ebbs, that may not be an isolated outcome. IG credit spreads, too, are unlikely to end 2021 meaningfully different from current levels, unless some currently unanticipated shock drives them wider.

Even 30-year US Treasury yields, while facing the brunt of upward pressure in recent weeks, may not necessarily end 2021 at substantially different levels to today. To phrase it differently, 30-year yields have clear two-way risk in the 1.50 to 2% area, despite an almost overwhelming consensus that they can only rise. We note that consensus was of the same view not just this time last year, but also at the start of almost every year in the past decade since 2010. While we are excited at the prospect of eventual economic reopening in 2021, we think consensus assumptions of one-way bond-yield traffic could be presumptuous. In our market experience, things don’t always pan out that simply. In any case, should rising yields be the theme for 2021, we think there may be more asymmetric opportunities to play it elsewhere. Alternatively, should the bearish consensus be wrong once again, it would hardly be the first time. The challenge then is to identify which markets may buck the theme of just another range trade.

The belly of a number of yield curves looks expensive in our view, suggesting outright shorts, or at least 2s5s steepeners in the front end of the US Treasury, Gilt and Bund curves. Away from rates, if credit markets are to surprise, the current herding of the bullish consensus and increasingly asymmetric valuations, suggest they can only do so on the bearish side. Stating this possibility in the face of widespread vaccine optimism, almost seems heretical, such is the strength of current consensus market belief. Yet that very fact increases the potential for surprise – and disruption of the consensus.

To help keep an open mind and question whether 2021 is necessarily a one-way bet for risk, consider the following five facts.

1. When the Spanish flu pandemic ended in the spring of 1920, the US still had another 1 and ¼ years of recession to go, given the economic double dip, while credit spreads remained at over twice current levels.
   
   
2. The last hike in US corporation tax, a flagship policy instrument of the new US administration, was enacted seventy years ago – to deal with the last extraordinary one-off jump in debt levels. How sharp are memories of 1950?
   
   
3. Despite the market crash in the spring, US equity markets enter 2021 having touched all-time highs in eight consecutive years, a streak that exceeds even the equity bubble of the roaring twenties.
   
   
4. Income inequality, already at multi-decade extremes heading into 2020, has only been exacerbated by the pandemic. How might that evolve in the next few years?
   
   
5. Disruptive sociopolitical events such as the (remarkably poorly named) Arab Spring and the Greek and broader Eurozone crises followed within a couple of years of the last major global economic and fiscal shock (the Global Financial Crisis). The tumultuous political and social events of the 1930s in turn followed the events of 1929-32. It would be remarkable if the events of 2020 did not in some respects influence the social, political and geopolitical contours of future years.
   
   

Market participants, often overly focused on cyclical and economic factors (and therefore often surprised and upended by secular and political drivers) may need to take a broader perspective about the future. It’s just possible the vaccine is not the only driver of markets in 2021-22.