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Outlook 4Q18 - Fixed Income

15 Oct 2018


Fixed Income

(slide 15)

3Q18: terminal rates repriced higher in both the US and in the Euro Area. Huge increase in Italy-Germany 10-year spread - Systematic importance of Italy

US Treasuries

(slide 16)

Is the FOMC underestimating how high rates will need to rise? Is the yield curve too flat to encourage investors to take duration risk?

  • The FOMC will probably continue to increase rates at a pace of 25bps per quarter until the cycle of economic expansion is threatened (mainly from global growth risks and via a stronger US Dollar)*;
  • A higher inflation could push higher the term premium. Inflation is a lagging indicator and may surprise on the upside if FOMC lets the economy overheat;
  • Despite the deflationary shock coming from EM, UST have failed to rally;
  • Higher bond yields until economic pain is seen?

(slide 17)

The Fed still derives its inflation view from the output gap. The FOMC dots are higher than market expectations

  • Investors clearly do not see the possibility of an increase in bond volatility. Despite EM turmoil, the global “safe asset” of choice has not rallied;
  • Stable TIPS BE rates despite deflationary pressures (EM currencies devaluations), but helped by higher oil prices;
  • In the upcoming midterm elections, if the Republicans manage to hold on to the House majority, investors may see a Trump second term as more likely;
  • Investors are already starting to worry about US deficits?

(slide 18)

FOMC: the path of least resistance is towards more rate hikes as the dual mandate has been met…until we get dire EM conditions…

  • The FOMC delivered the expected 25bps rate hike at the September meeting. The statement and the updated dot-plot were seen as less hawkish than feared by the market;
  • Over the long-run, short yields should be around the growth rate for trend-nominal GDP (term-premium added for the long-end of the curve);
  • Concerns about the yield curve may even abate;
  • The Fed does not see major imbalances, which allow rates to continue to increase;
  • Focus remains on wage growth. Will we get wage growth above 3% over coming quarters ?

(slide 19)

Could the short-run neutral rate move above the longer-run federal funds rate  estimated by FOMC participants over the next year or two?

  • The Fed has historically had a high bar for changing course in response to foreign events. Fed funds rate usually does not exceed the peak in 10-year UST yields;
  • Governor Lael Brainard cited the expansionary fiscal policy and heightened risk appetite as reasons why the short-term neutral rate would have moved up relative to depressed levels. In his Jackson Hole speech, Jerome Powell stressed the uncertainty around measuring the neutral rate;
  • Until the curve inverts, the rate-hike cycle may continue to push all yields higher. Concerns regarding financial stability vs. need to have ”dry power” in the next recession.


(slide 20)

ECB moves slowly in order to allow the economy to improve. The scarcity of risk-free assets in Euro Area vs. QE stock effect. Italian political risks

  • Reinvestment policy I: Core yields at the long end, especially in real terms, remain at a low level, which reduces incentive to go ahead with “Operation Twist”;
  • Reinvestment policy II: Duration extension on reinvestment could flatten the curve, longer reinvestment window, ECB optionality;
  • Inflation risk premium higher in the euro area vs. the US;
  • Private sector saving/investment balance reduce room to ECB raise interest rates.

(slide 21)

Is the market under-pricing the ECB hiking cycle in 2019-2020? Focus on economic data (too early to the higher inflation theme?) and ECB soft guidance

  • The ECB remains upbeat on core inflation acceleration, on the back of positive labour-market developments (feeding into wage formation) - Higher sensitivity to HICP inflation data;
  • Benoît Coeuré suggested in a speech in September that the appropriate policy rate in mid 2020 would be around 10bps, with an estimated range from +25bps to -25bps;
  • Peter Praet and Mario Draghi leave the ECB next year (risk premium on 5y). Financial conditions in the region will remain key (less powerful forward guidance?);
  • Inflation pressures stemming from lower spare capacity. Central banks are removing policy accommodation (which puts upward pressure on term premium).

(slide 22)

As central banks remove policy accommodation, upward pressure is expected on term premium. Core and semi-core have received support from BTPS weakness

  • Global yields are correlated to US Treasuries;
  • Are monthly redemptions in the PSPP programme large enough for markets to pay attention?
  • Portugal & Spain apparently immune to Italy. And what about Greece? (Election expected to take place next year)
  • And what about redenomination risk in Italy? If Italy were to try to redenominate its sovereign debt, there will be significant implications for the rest of Europe, in particular to the Euro Area periphery.

(slide 23)

Italy: GDP growth remains a key variable to watch given its importance in debt and domestic political dynamics. Bond vigilantes vs. European Commission

  • Fitch, S&P and Moody’s all have Italy two notches above junk status*. DBRS has Italy three notches  above (important in the ECB context). Higher Italy-Germany spreads could lead to downgrades by rating agencies?
  • Italy has a current account surplus, a primary budget surplus and most of its debt is owned by Italian entities & the ECB;
  • The main problem could be the path that the current coalition government is taking (unlikely to address structural issues?);
  • Tension could reach a peak in the next recession.

(slide 24)

Lack of contagion from BTPs …Are current Italian bond spreads attractive?

  • Strong legal barriers to Italy leaving the euro;
  • Italy’s exit would make impractical the monetary union;
  • UW BTPs  induces large flows to other EGBs markets;
  • Rating agencies will likely follow the news;
  • How soon will investors show fatigue about the headlines around Italian fiscal policy;
  • Major risk: Italy is shut out of the bond markets.

Emerging Markets

(slide 25)

A lot is already priced in... But are EM assets ready for higher UST yields and heightening geopolitical tensions between the US and China ?

  • Valuations have already improved. However, higher US rates remain a key risk for EM assets, as the FOMC continues to tighten monetary policy;
  • Has the fixed income market already priced the strength of the US economy? Could this still be a stress for emerging markets?
  • Widening in USD-denominated EM sovereign spreads has been concentrated in Turkey and Argentina;
  • China PMIs point to moderation in manufacturing;
  • Current account pressures coming from high oil prices.

(slide 26)

In China, the latest PMI report shows that policy adjustments may have started to boost activity in certain parts of the economy (construction)

  • Cautious monetary and fiscal stimulus. Bottom in economic growth over coming quarters?
  • Good news on US growth could still push bond yields and the US Dollar higher. Markets may still have to discount a faster pace of tightening by the FOMC next year;
  • Monetary tightening implemented by EM central banks has helped sentiment towards EM (headwind for local-currency borrowers to pay back loans and to economic growth);
  • Monetary policy vs. RMB. Supporting the economy vs. reducing leverage ratios.

(slide 27)

Latam: vulnerability to balance of payments stresses, given the backdrop of rising US rates, stronger US Dollar and slowing global trade

  • Brazil: government gross debt & fiscal balance (-) vs. private saving/investment balance & external debt & current account (+);
  • Mexico: net international investment position (-);
  • Argentina: fiscal balance & current account (-) vs. NIIP (+);
  • Colombia: government debt (-);
  • Chile: external debt (-) vs. current account (+).

(slide 28)

Brazil: the currency remains key to the performance of sovereign debt. More challenging backdrop for structural reforms would push the SELIC rate up

  • Considerable fiscal austerity & privatisations to prevent Brazil’s public debt to become uncontrollable;
  • Jair Bolsonaro & the swing to the right in Congress/Senate;
  • There is a huge gap between short-term and long-term interest rates in BRL terms. COPOM does not see enough deterioration in the inflation outlook to push for tightening cycle;
  • Structural reforms needed to address a growing deficit in pensions and budget rigidity (impact on monetary policy);
  • 90% of Brazilian sovereign debt is denominated in BRL.

(slide 29)

Argentina: the stock of debt in private hands stood at 26.6% of GDP as of 31 March 2018 (lower market rollover risk)

  • Peso is more than three standard deviations below its 10-year average, suggesting adjustment is probably already advanced. Private sector foreign asset purchases continue at a rapid pace;
  • In Argentina, President Macri will go ahead with the reforms required by the IMF, even if he is likely to be punished at next year’s general elections. The larger IMF standby loan reduces the risk of government default;
  • FX impact meaningful, given the large share of hard-currency debt. FX crisis induces a faster reduction of imbalances, which should reduce external and public financing needs.

(slide 30)

A meaningful improvement in Chinese growth would be an important tailwind…

  • Mexico: At 7.75%, the policy rate is already at a relatively restrictive level, in both nominal and real terms;
  • Mexico: Focus should be on potential reforms in the oil sector given that it can improve or deteriorate the public finance outlook;
  • Colombia: High oil prices provide an important buffer, in spite of increased uncertainty around the tax reform;
  • Colombia: Improvement in the current account reduces exposure to portfolio flows. Commitment to reform will be key.


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