23 MAR


Fixed Income , Asset Class

Global context: robust activity-cycle momentum

The activity-cycle momentum remained robust over the month, led by the Eurozone and the US, with the expansion stage remaining well-anchored in both regions, although not in the UK. In the US, the economic momentum remained strong, thanks to very positive ISM Manufacturing, Consumer, Confidence, and Labour Market prints. Moreover, ISM Services and Capacity Utilization have witnessed a rebound. In the Eurozone, momentum continues to build, with the economic sentiment indicator still very positive. Growth is pointing upwards in most countries in the G10, as activity cycles are in expansionary territory in all states except New Zealand, which would need more policy accommodation. We have, finally, noted that the pace of QE purchases of Sweden’s RiksBank has noticeably slowed in recent months.

The inflation cycle continues to gradually strengthen across the board, with the US and the Eurozone still leading the way, while Japan and UK present a mixed bag. In the US, the inflation trend has increased significantly over the past 6 months, with all indicators (producers, wages, and expectation) up. In the Eurozone, inflation dynamics are expected to improve by mid-year in some sub-indicators, particulary wages. We are already seeing an improvement in the expectations component, which is now contributing positively. In the UK, the inflation cycle appears to have reached a peak, with a housing component that keeps decreasing. All in all, the inflation picture is exhibiting an upward trend across developed markets, with nearly all countries in the inflation or reflation phase of the cycle.  

Europe seems to be holding fast on the debt-cycle front, while the slowdown in US credit creation continues, weakened by a low loan demand due to US policy uncertainties, higher leverage and bond supply. Furthermore, Japan and the UK have joined in the decline, though their credit growth appears to be continuing, but at a slower pace. This is an important factor to be taken into account, as the debt cycle is a leading indicator for the activity cycle. Hence while we do not foresee any immediate declines or necessary cause for alarm at this juncture, this indicator does call for a cautious stance.

Regarding the monetary cycle, the US outlook keeps on shining, with 3 to 4 hikes scheduled for 2018. We continue to monitor communication from new chairman Powell and revisions from their economic projections (SEP).

In Europe, the ECB amended its communication to prepare markets for the end of QE. Indeed, it has withdrawn the mention that a QE upsize could be considered. At the press conference, Mario Draghi kept a very balanced tone and the ECB reviewed its inflation forecast from 1.5% to 1.4%. We expect a very gradual adjustment of ECB policy, with a first hike not before Q2 2019.

Global rates strategy

Short positions in the US and Core Eurozone

In light of the improving macroeconomic outlook and better inflation numbers in the US, we continue to hold a short position on the US curve. The increase in federal outlays as laid down in the 2018 budget should have a greater impact on growth. The US will incur a fiscal deficit (to the tune of 7% of GDP) during an activity cycle that is already in its 9th year of expansion. This would justify a more restrictive monetary policy and higher interest rates, which the latest FOMC has confirmed. We have maintained our cautious view on the short end of the US curve as markets continue to underestimate the pace of Fed tightening in 2018. It is important to highlight that we remain flexible and moderate on this position as market positioning appears to be quite high on the short US rates trade in 5Y. In Europe, the continuous rise in the activity cycle and the ECB’s QE tapering keep us holding a short position on the EUR curve. However, such positioning is not supportive, as investors’ long positions remain substantial. Supply and Demand dynamics should appear mixed in March and supportive in April, with €25bn redemptions in PSPP alone. We hence tactically reduced our underweight duration on German rates. Next ECB meeting scheduled for April 25th.

We favour Portugal, Ireland, Spain vs. Italy in our non-core allocation 

The non-core European bond markets are still supported by the ECB, and flow dynamics are also positive. Despite the reduction in purchases by half from January 2018, purchases and reinvestments remain sizeable in an open-ended programme. While the overall growth and macroeconomic outlook remain strong, positioning has started to look less attractive as investors have substantially increased their bias to peripheral sovereign bonds. Regarding the Italian elections, the main short-term event risk is currently related to the formation of the government as no clear majority was won while populist party (M5S and LN) gains were more than expected. As we believe that very little of this political risk has been priced in, we are maintaining a cautious stance on Italy. Strong flow and economic dynamics in Spain support our positive view on that country.  A further upgradeby S&P ratings at the end of March could offer further support. Also, on Portugal and Ireland, we are keeping a positive stance.

Exposure to US, Canadian Break-evens

The overall framework for inflation-linked bonds is tending to reduce our positive stance on this asset class, with the exception of the US and Canada. Indeed, US break-evens – supported by a positive carry profile – appear particularly attractive. The inflation cycle remains strong, despite somewhat disappointing data more recently (average hourly earnings). In this context, we are maintaining our long exposure to US break-evens. Furthermore, valuations also continue to be attractive on Canadian linkers, although we are now more cautious on Japanese ones. In the UK, on the other hand, valuations remain expensive. In this context, and in spite of some less favourable inflation data recently, we hold a favourable view on break-evens in the US and in Canada.