Three months ago, in Coming to America, we highlighted that value had begun to build in US Treasuries – and would soon arrive. This followed the rapid cheapening in Q1 amid outsized US fiscal announcements, the DM growth recovery, reopening and investor confirmation bias as inflation base effects kicked in.
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Still waiting on the Fed
Before going long real yields from a fundamental perspective, however, we explained that the Fed would first need to announce their widely anticipated tapering policy. Having taken profits on our US Treasury short several weeks ago, we find, three months on, that we are still having to wait for the Fed to get round to moving into the next policy phase, even though 2021 is still on track to be the strongest year for US growth in at least 36 years! The upshot has been a quarter of Fed procrastination, even though the BoE and BoC have got on with the job and announced tapering of their own purchases.
For the Fed, by contrast, we think the ghost of 2013 looms large, making them adopt an overly cautious stance. Nevertheless, we must respect that their new FAIT framework means this will be a gradual process, unless the data or markets force their hand. This has left rates markets essentially on pause in Q2, joining what had already become sideways price action in credit, after the drama of 2020. Sometimes markets sprint (H1 2020 across fixed income, January and February in US Treasuries) and sometimes they crawl. Most of fixed income has crawled since March. Still, the lesson from such prior episodes – summer 2014 and H2 2017 spring to mind – is that, eventually, policy eases off and volatility returns. So, we are mindful that getting sucked into carry trades or expecting low rates volatility from here on are more likely to be dangerous assumptions than not.
In duration, we think market participants have become too short on those curves globally that are too steep, wielding secular inflation regime arguments that are, for now, too specious. Some have positively hyperventilated about inflation. Yet much of what has occurred was known a year ago. Front-end oil contracts fell from USD 70 pre-Covid to below USD 0 and back up to USD 70 again, yet we take a different view to the consensus as to which one of those numbers is more remarkable. The consensus is fixated on a 5% headline CPI, in year-on-year terms. Airline and travel inflation in early summer 2021, when compared to activity which was essentially de minimis last year, tells us little. The level-versus-flow distinction we discussed last year remains relevant. Moreover, the trouble with expectations is that when they are already hyped up, it is harder to achieve right-hand tail surprise outcomes.
Meanwhile central banks have taken the ‘transient’ view on current inflation dynamics, resulting in a Fed and ECB on pause. For those in bearish duration positions in steep fixed income curves with negative carry and finite patience, the recent outcome has been clear: capitulation.
To be clear, we think the lower yields in recent weeks are market related rather than a fundamental move – fully understandable given the lopsided nature of bearish investor positioning in fixed income and the ferocity of moves earlier in the year. We also view prospects to make money through shorting duration quite differently in different markets. We think curve slope, not absolute yield, is a more important valuation metric to watch. That means looking for short opportunities in Gilts and the EUR 2s5s curve, where there is comparative flatness, at least versus the US and dollar-bloc curves at present. While many people like to focus on 10-year US Treasuries when they discuss or take active views on fixed income, we think the opportunities will require a bit more imagination and a more global perspective. We continue to believe cross-market and curve trades have higher information ratios than directional duration positions and we suspect developments in Q2 may make others begin to think more along those lines too.
The outlook for credit still is ‘either boring or bearish’
In credit, we think IG and HY markets, at their tightest levels since Q2 2007, look pretty much as good as it gets. While both rates and credit have been somewhat directionless for the past three months, we think rates will continue to provide the better active opportunities, and don’t foresee huge movements in credit – certainly not on the tightening side. As we said in December 2020, the outlook for credit in 2021 is either boring or bearish.
Heading into H2, we still find plenty to disagree with in the prevailing market consensus. The 2021 dollar weakening trade continues to look suspect, and many of the secular inflation regime arguments look poorly constructed. The bearish fixed income consensus also seems to overlook rates market dynamics hidden behind nominal spot curves: we think breakevens tend to narrow during periods of central bank tapering; and we note 5y5y forwards tend to peak in the calendar year after recessions. Taken together, these points mean care will be needed as the Fed and ECB address the outlook for QE and PEPP into Jackson Hole and the September meeting, respectively. It also implies that prevailing consensus market trades might struggle, which in turn ought to provide opportunities. We may not have a sprint in markets in Q3, but a crawl is unlikely to last forever.