24 NOV


Fixed Income , Asset Class

Flattening in the US and short core Eurozone

Global Context

The activity-cycle momentum continues to build in the Eurozone and in Japan, with the expansion stage remaining well-anchored in both regions. In the US, the picture has improved substantiallyas economic indicators appear to be quite positive (namely strong ISM prints both on the manufacturing and the services segments) and unemployment figures continue to remain low. While awaiting confirmation of this improvement, we continue to monitor the events surrounding the much-awaited tax reforms and fiscal stimulus, which are important factors in determining the state of the US economy. The other developed countries are a mixed bunch, as Australia and Canada (which continues its acceleration) are in the expansion stage, while the UK and Sweden are experiencing a downturn. In terms of inflation indicators, we await information in the coming months on which to assess the effects of the recent oil-price increase on the inflation cycle, which appears to have peaked.

On the debt-cycle front, the slowdown in US credit creation continues, weakened by lower M&A activity, weaker loan demand due to US policy uncertainties and higher leverage. In spite of the stability exhibited by the European and Japanese debt dynamics, the overall debt-cycle index is moving lower. This is an important factor to be taken into account as the debt cycle is a leading activity-cycle indicator. Hence, while we do not foresee any immediate declines, this indicator does call for a cautious stance.

Elsewhere, the monetary cycle does not appear to be excessively restrictive as rate-hike pressure continues to subside in the US. Additionally, the recent nomination of Jerome Powell as the successor of Fed Chair Janet Yellen should temper expectations as Mr. Powell is known to favour a slow and gradual hike in rates. However, we will continue to monitor the changes on the board of the Federal Reserve as some longstanding members will be ending their mandates shortly (Fisher, Dudley). In Europe, even though the ECB did announce a reduction of its QE programme (to EUR 30 billion/month), the programme was extended till September 2018 and remains open-ended. All in all, hiking pressures have subsided across the developed markets. 


Flattening in the US and short core Eurozone

The curve-flattening strategy on US treasuries that was implemented has been profitable over the past few months. We have maintained a cautious view on the short end of the US curve as markets continue to underestimate the pace of Fed tightening in 2018. Though macro-economic figures are encouraging, there continues to be uncertainty around the fiscal reforms and particularly the tax reform bill, which is already generating a fair amount of disagreements and debates. Without these reforms, we remain wary of growth momentum in the US, thereby justifying our long position on the higher maturities of the US curve. It is important to highlight that we remain flexible and moderate on this position. In Europe, on the other hand, the continuous rise in the activity cycle and the recently announced additional tapering of the ECB QE has incited us to continue to hold a short position on the EUR curve. Valuations continue to be at extreme levels, especially on German rates, thereby comforting us in our strategy.

Positive on Portugal and Italy but cautious on Spain

The non-core European bond markets continue to be supported by the ECB, and flow dynamics are also positive. Furthermore, investor-positioning remains close to its record lows. The political risk in Europe appears to have reduced as the quest for independence in Catalonia has been smothered by Madrid. Indeed, the Rajoy government has already arrested key members of the former ruling party in the region, as well as its former leader, Mr. Puigdemont. Though the spectre of the December elections in Catalonia does linger, the short-term worries have subsided. Furthermore, in Italy, the reforms on electoral laws have gone through, favouring coalitions within the government. As the populist 5-star party has stuck to its policy of not participating in coalitions, it is unlikely that they will enter the government at this stage. In this context, we have a slightly more favourable view on peripheral sovereign bonds, though we continue to remain cautious on Spain. We are now slightly underweight on Spain and have no more exposure to Spanish regional debt. It’s a tactical position, as we remain confident about Spain economic fundamentals, with a strong economic recovery (more than 10%) seen since 2014, and we continue to follow the political situation and reassess our positive economic view on the country. Among the non-core countries, we currently favour Portugal, which has been upgraded back to investment grade by S&P (from BB+ to BBB-), which cited better growth prospects and the “solid progress it has made in reducing its budget deficit and the receded risk of a marked deterioration in external financing conditions. To a lesser extent, we also have a favourable view on Italy on the back of the recent upgrade in ratings and drop in political risks.

Exposure to US and Eurozone Break-evens

The overall framework for inflation-linked bonds is pointing upwards as our global scores on break-even protections have turned more positive, balancing out a mixed inflation-cycle indicator. The asset class posted a better performance in October, especially in Japan. The combination of rising commodity prices, signs of wage pressures (see IG Metall in Germany) and still-improving economic dynamics is supporting our positive view on Euro linkers. The positive carry environment both in EUR and US is adding to the equation. Valuations also remain attractive while our break-even momentum model is positive both on EUR and US linkers. In the UK, on the other hand, valuations are more expensive. In this context, and in spite of some caution on the inflation cycle, we hold a favourable view on break-evens both in the US and in the Eurozone.