22 JUN

2017

Fixed Income , Topics

Tactical defensive stance on linkers, continue to take profit

Global Context

After a rather encouraging run since the beginning of the year, the business cycle is experiencing a slight lull, primarily driven by the US. Economic momentum in the region appears to be taking a breather as illustrated by our proprietary indicator that points towards a drop in the probability of economic expansion. We are also keeping a keen watch on the debt cycle which is slowing down, as it tends to be a leading indicator for economic activity. In spite of this observed soft patch, certain forward indicators such as ISM services remain solid. Further grounds for optimism in the G4 region come from the Eurozone business cycle, where momentum continues to build and the probability of expansion remains strong.

Although the inflation cycle continues to point upwards in the G4, supported by sharp up-ticks, especially in the Eurozone, the reflation trade is taking a breather as dynamics appear to be slowing. In the US, the probability of inflation is decreasing slightly, though the overall picture remains positive. Hence, broadly speaking, the reflationary trend is going to be a challenge for central banks, and could force them to adopt a more hawkish stance as markets continue to expect rate hikes throughout 2017 in the US. In terms of the credit cycle, debt dynamics in the US are slowing, with a sharp decline in consumer loans. When combined with a business cycle that is still positive, the overall credit cycle remains in bullish consolidation, though it will be important to monitor this factor as weakness in the business cycle could lead to a downturn.

 

GLOBAL RATES STRATEGY 

Tactical defensive stance on linkers, continue to take profit

With the overall framework on inflation-linked asset class becoming less supportive, we continue to take profit on our remaining euro linker positions. Specifically, we are taking profits on our short-end linker positions, which performed well vs nominal, supported by inflation carry. Overall, in the medium term we do see potential for this asset class. However in the short run, with decreasing carry support going forward and limited short term upward potential for euro inflation, we prefer to adopt a prudent stance and lock-in profits on the back of a strong YTD performance.

 

Spread trade long US vs. short Eurozone

While the overall business cycle is positive, it is no longer accelerating as in previous months. Furthermore, it is important to note that the credit impulse is markedly lower. In spite of hawkish signals from the Fed, rate hikes should remain gradual. Finally, the woes of the current administration continue to weigh on markets as President Trump now faces accusations regarding possible leaks of sensitive information from the Oval Office and the unexpected firing of Mr. Comey, the former FBI director. Finally, we have noticed that the level of short positions on the mid to long end segment of the US Curve continues to decrease, as investors seem to be unwinding the trade. In light of these events, we aim to hold long exposure to US rates. 

In Europe on the other hand, we take note of further acceleration in the business cycle. We also acknowledge that the credit impulse is very much present. The monetary policy rhetoric points towards a more hawkish stance and calls for ECB QE tapering are increasing. There has already been a sharp reduction in the PSPP purchases in April, and an adjustment of QE is expected to be announced in the coming months as we approach the limits of the program. With the election of Emmanuel Macron (Pro-European candidate) and the defeat of the far-right, political risk has diminished considerably in the Eurozone. Furthermore, core markets remain expensive with rates at extremely low levels. In this context, investors may no longer focus on safehavens and EU core rates (especially German rates) are likely to rise. Our stance on non-core sovereigns in the Eurozone remains positive. Investor positioning, which had been reduced earlier in 2017, has increased again on the segment. We hold a tactically favourable view on Portugal while we locked-in profits on our tactical long stance in Italy.