Well, what a start to the year! Several things are coming to America. A new Democrat administration keen to sprint out of the blocks, outsized fiscal easing, and wider breakevens (already at well above pre-pandemic levels) are already here. From now, should no mutation hitches stymie reopening plans, outsized job gains, inflation base effects, consumer spending and growth should follow. Then, contingent on the job gains, we should expect the first Fed comments on tapering, probably in May. While value has already begun to build in US Treasuries, with 5y5y forwards already above the Fed’s median longer-run dot, the coast may not be clear – particularly for real yields – until the market has fully priced in tapering.
Beyond the USD 13 trillion US Treasury market, the USD 34 trillion global government complex remains a source of active differentiation – and therefore alpha (both long and short) – within the USD 66 trillion global aggregate universe opportunity set. Correlations, too, are as dynamic as ever, with Bunds and JGBs seeing less than a third and an eighth of the volatility of Treasuries over the year to date. And Italy, China and even the 2yr US Treasury have delivered positive returns for material periods, offering comparative respite. Even in Q1 2021, amid sharply rising yields, you needed to have picked your shorts carefully, by geography and maturity.
Beware the base effects
For Q2 portfolio strategy, we expect to rotate shorts from the US to Bunds in due course, anticipating that the EU’s vaccination programs will eventually get in order and that the ECB will shake off its current timidity over the mighty heights of -0.25% Bund yields. Gilts should continue to bear steepen, albeit to a lesser extent than the US, given greater proposed fiscal restraint. The JGB long end should steepen, too. We think an opportunity on the overweight side will emerge in China as extraordinary economic stimulus from 2020 rolls over first in that market, given that China’s economic hit predated that of the west. Markets are focused on base effects of growth and inflation, but don’t forget the base effects of policy and credit creation.
In credit, investment grade (IG) spreads offer little value in our view – with year-to-date returns in credit heavily dominated by duration rather than the option-adjusted spread (OAS) component. The only difference in investment proposition is that credit carries a bit better than rates, at the cost of considerable latent illiquidity risk. But whereas the underweight in duration is cyclical, we view our underweight in credit as tactical. We expect a much narrower range in IG in 2021 than last year’s drama (see: “Just another range trade”).
High yield may offer opportunities too as the quarter progresses, though the big gains were in Q2 last year and cannot mathematically be repeated this year. On emerging markets, while we do not expect volatility to the same degree as 2013, caution is warranted. The sell-side consensus has been surprisingly accurate on its call in 2021 for higher yields, wider breakevens and steeper curves; however, the call for a weaker dollar looks more suspect: emerging markets would see the most fallout if the dollar consensus slips on a summer tapering banana skin, so a ‘basket case basket’ may be in order on the short side.
Some careful management is needed
Both duration and credit will need to be carefully and actively managed this summer. The Q2 market movie may not be a PG-rated one: real yields tend not to fall when the Fed begins the multi-year process of communicating its intentions and then withdrawing stimulus. And, because markets anticipate, volatility should be frontloaded. At the same time, should monetary policy become less reflationary, breakevens could get crushed, thereby turbocharging real yields – with both components thus reversing the standard pattern on the ‘announcement effect’ of QE. A real yield rise, if combined with a stronger surprise on the dollar, would upend several of the more expensive asset classes (particularly the raciest ones outside of fixed income). Beyond tapering concerns, it is quite possible that a separate dual policy mistake is unfolding before our eyes, with excess and poorly targeted fiscal spending together with the monetary experiment of flexible average inflation targeting (FAIT).
Still, after any 2013-type summer market drama, we expect underlying economic fundamentals to stay intact. After all, 2021 is still on track to be the strongest year for US growth in at least 36 years and, for Chinese industrial production, the best ever in year-on-year volume terms. So much for deglobalization. In contrast to 2020, volatility is more likely to come from market (and possibly social and political) factors than economic ones. And once the market has priced in the economic outlook – 5y5y forwards tend to peak in the calendar year after recessions – active fixed income can be played from the long side once again, rather than the short. After Democrats and fiscal easing, we expect that jobs, reopening, recovery, tapering – and finally fixed income value – is coming to America.
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