BlueBay AM: It's all set to heat up from here
By Mark Dowding, CIO at BlueBay Asset Management
Following a US cold snap, it looks like the move-up in yields could raise the temperature of global bond markets.
A building reflationary theme continued to put upward pressure on yields over the course of the past week as Covid infections continue to drop and moves are made to ease restrictions on economic activity.
Thus far, the US curve has been in bear-steepening mode. However, with long-dated yields breaching 2%, it has been noticeable that shorter-dated yields have also started to rise somewhat and it has been interesting to observe that, as this occurs, so this move is starting to have more of an impact on risk appetite for other assets.
Fiscal easing is seen pushing US growth towards 7% in 2021 after a -2.5% decline in 2020. In this case, we estimate that the Covid-induced output gap will have closed before the end of the year and as sectors such as hospitality normalise, we would not be surprised to see unemployment back to 4% by December.
At the same time, we believe that core PCE inflation may well breach 2.5% in the spring. Consequently, we could see Federal Reserve (Fed) messaging start to shift before we reach the summer.
Currently, futures markets discount a first FOMC rate hike in the middle of 2023, though we would not be surprised if this doesn’t come at an earlier point – especially if we are correct in our view that the fiscal Covid relief package will be followed by further initiatives with respect to infrastructure and green technology later this year.
In this way, we see fiscal stimulus continuing to support growth in 2022 and 2023, as the Biden Administration adopts a stance which should see the share of government spending increase in the context of the broader economy.
Forward curves now discount 10-year US yields just above 1.5% at the end of 2021 and we believe that there is scope for this move in yields to run further in the weeks to come. We continue to maintain a short duration stance, though have shifted part of this positioning to the shorter end of the curve via Eurodollar contracts.
Across the Atlantic
European yields have also tracked moves in US Treasuries. At this point, it would appear very premature to begin to discuss higher eurozone interest rates, though as the macro backdrop improves, we may expect moves to wind down the PEPP purchases in 2022.
For now, net supply of eurozone government bonds remains in negative territory and this has helped to drive spreads tighter; this dynamic is unlikely to change for some months to come. However, we believe this picture will change next year and it is also possible that we could see greater political volatility in 2022.
Currently, we are in the Draghi honeymoon period, with optimism prevailing in Italy. Yet, we remain concerned that a tough job lies ahead and it won’t be too long before this hope starts to fade.
The outlook in corporate credit is fundamentally supported by improving economic prospects and yield-sensitive buyers have been active, as higher yields have created an opportunity to ramp-up purchases. Lower-quality, high-beta credits continue to outperform, with reflation continuing to translate into credit compression in corporate bonds.
By contrast, market sentiment in emerging markets (EM) has proven somewhat more fragile over the past few weeks. In part, this may be explained by differentials in relative supply. A fairly large volume of EM issuance since the start of the year contrasts with relatively muted supply in sectors such as high yield.
Despite healthy order books, it seems that an amount of participation has been from accounts looking to flip bonds for a short-term trade and therefore, falling prices as underlying Treasury yields rise mean that there has been a poor technical overhanging parts of the market.
Some US dollar firmness has also weighed broadly on EM, though since the start of 2021 it has been noticeable that EM currencies as a whole have been trading better than their developed-market counterparts. In part, this is explained by interest rate differentials and cheap valuations. However, robust commodity prices have also been supportive.
The cold snap in much of the US over the past week has seen oil prices up to their highest levels for the past 18 months, supporting the currencies of oil-exporting countries, such as the Russian rouble. Meanwhile, improving fundamentals continue to fuel improving sentiment with respect to assets in Turkey.
We feel that moves in US yields may play a critical role in shaping broader market sentiment in the next couple of weeks. A continued sell-off in Treasuries from current levels risks creating more of a ‘risk-negative’ market narrative. This may be particularly prevalent if the move sees shorter-dated yields pushing higher and the yield curve moving in a more parallel fashion.
We also believe that a move higher in real yields could act as a negative catalyst for sentiment more broadly. Thus far, real yields have been largely anchored, with moves in yields in nominal bonds simply lifting the break-even inflation rate on US Treasury inflation-protected securities. However, we feel that this could be set to change in the coming weeks.
This said, we still feel the Fed will be keen to stop financial conditions starting to tighten too quickly when there is still a lot of slack in the economy and they are keen to do all they can to stimulate demand and drive inflation down. Therefore, we believe that as yields go up, so Fed speakers will become more vociferous.
Additionally, should a move in yields trigger a risk-off trade and a flight to quality, this will in turn see that yields head back down again. In this way, any sell-off in rates could prove self-correcting.
Meanwhile, if the recent rise in yields takes a pause for now, we still think we are in an environment in which many assets can continue to perform well, thanks to accommodative policy conditions and improving newsflow.
Elsewhere, dwelling on the crazy cold temperatures in much of the US over the past week, it is tempting to project forward and conclude that winter will soon come to an end. It certainly looks like it may get a bit hotter from here. It could also get a bit hotter in markets, if the move-up in yields continues to run.