In its quarterly outlook, the Global Fixed Income Macro team sees central banks gradually normalizing their policies. As inflationary pressures are low, central banks are not likely to act aggressively and upset financial markets. Emerging market local debt looks attractive as inflation is falling in most emerging countries. This should lead to lower bond yields.
In recent weeks, synchronized hawkish rhetoric from major central banks has pushed bond yields higher. Key comments from European Central Bank President Draghi and Bank of England Governor Carney triggered speculation that a shift away from the period of extremely low or negative interest rates and quantitative easing (QE) is imminent. The Fed is openly contemplating when to start reducing its balance sheet and raised official target rates in June for the fourth time this tightening cycle. Then there’s China, where the People’s Bank of China (PBOC) is trying to find a balance, tightening monetary policy to address excessive leverage in the financial system without causing a credit crunch.
To us it makes sense for central banks to start policy normalization, with buoyant financial markets and world economic growth likely to move up in the coming years. However, lackluster price pressures and structural problems, such as low productivity growth and high income inequality, indicate that this policy normalization will be very gradual. So don’t expect central banks to step on the brakes aggressively and derail financial markets. Other tail risks, like China’s alarmingly rising leverage, are better positioned to emerge as a catalyst for a spike in financial markets volatility.
Compressed yield levels in European core bond markets look unattractive versus US bonds from a risk/reward perspective. We expect the US-German yield differential to converge. The economic upturn in the euro area gathers pace while in the US a growth impulse via tax cuts looks far off and the Federal Reserve’s projected rate hike path is challenged by a shortfall in inflation. As the differential between 10-year German and US yields still trades close to historical highs, we prefer US Treasuries to German bunds.
We stick with our positive stance on emerging (local) debt, although substantial return differentiation between countries will continue to be a feature of this asset class. In several countries there is scope for (further) monetary stimulus as inflation is falling. This should be supportive for their respective local rates. As inflation is moving lower, real yields continue to look attractive versus other bond markets, especially those in the advanced economies. The inflows into the asset class can continue, as the positioning of global fixed income investors in this segment does not look extreme yet.
The local rates market of Mexico remains our favorite. We are confident that the government and central bank will be successful in driving down inflation in the near future, just as their regional neighbours have been recently. There are two country-specific factors that have driven Mexican prices higher, i.e. the weakness in the peso up to and after Donald Trump’s election as US President in November 2016, and the final liberalization of domestic oil and gas prices at the start of 2017. Not only are the worst calendar effects of these factors now behind us, the Banco de México has also increased interest rates significantly in order to counter the risk of additional inflation pressure or higher inflation expectations. In anticipation of the central bank’s success in fighting inflation we are positioned in the belly of the Mexican swap curve.
Recently, we also initiated a long position in the Russian ruble after it had come under pressure when EU and US sanctions were extended and oil prices had dropped.
We re-initiated a short position in the Italian and Spanish bond markets. In the aftermath of the French elections, peripheral spreads have tightened. The main reason for our change in positioning is that current spreads do not compensate for the move to monetary policy nomalization (i.e. the gradual phasing out of ECB bond buying).
Our preferred credit category is subordinated financials. Their valuation is attractive versus other credit categories. Furthermore, an environment of rising yields and steeper yield curves is supportive for the financial sector. Asian credit and high yield corporate bonds look less attractive given their current valuations.
The figure below summarizes our views on the attractiveness of government bond markets and specific fixed income assets, based on valuation, technicals and fundamentals.
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