23 JAN


Fixed Income , Topics

The activity-cycle momentum continues to build in the Eurozone and in Japan

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 substantially,as economic indicators appear to be quite positive (thanks to continued strength in ISM prints both on the manufacturing and the services segments) and unemployment figures remain low. The much-awaited tax cuts and job reforms are likely to support short-term GDP growth to the tune of 0.2-0.3%. Growth is pointing upwards in most countries in the G10, as activity cycles are in expansionary territory in all states except New Zealand. In terms of inflation indicators, the US and the Eurozone appear to be the leading the way, with rebounding expectations. The increase in oil prices continues to contribute positively to the overall picture, with the WTI having risen over 10% since the beginning of December. Other G10 countries present a mixed bag, as the UK, New Zealand and Sweden are in the cooling stage and Norway is experiencing fast declines with respect to our inflation indicator.

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. Furthermore, Japan (and, albeit to a much lesser extent, the Eurozone) has joined in the decline, though their credit growth appears to continue but at a slower pace. This is an important factor to be taken into account, as the debt cycle is a leading indicator of 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.

Elsewhere, the monetary cycle does not appear to be excessively restrictive but hawkish winds are howling on the back of improving activity and inflation cycles. Following better macroeconomic and inflation prints, the Federal Reserve appears to have enough room to hike rates in the US and the Fed dot plots indicate three hikes in 2018. We continue to monitor developments related to the potential changes on the board of the US central bank (three members stepping down in 2018). In Europe, the ECB has already tapered its QE programme (to EUR 30 billion/month), a pace due to continue till September 2018 (or longer, if needed) and that remains open-ended. However, dissensions within the ECB ranks have started to appear, with certain officials calling for lower levels of accommodation. Hence a potential extension of the current pace of asset purchases (later than September) is likely to be a tough sell in the current context. 


Short positions in the US and Core Eurozone

In light of the improving macroeconomic outlook and better inflation numbers in the US, we aim to hold a tactical short position on the long end of the US curve. The implementation of the recently agreed-upon fiscal reforms is also likely to temporarily support US growth levels. As a consequence of the hefty fiscal package (which included tax reforms) that was passed, the US will incur a fiscal deficit (to the tune of 5% of GDP) during an activity cycle that is already in the later stages of expansion. This would justify a more restrictive monetary policy and higher interest rates. 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 data continues to trickle in. In Europe, on the other hand, the continuous rise in the activity cycle and the recently announced additional tapering of the ECB QE have incited us to maintain a short position on the EUR curve. Valuations continue to be at extreme levels, especially on German rates, thereby comforting us in our strategy. Furthermore, as the ECB faces increasing calls to adopt a more hawkish stance, core rates will continue to face upward pressure.


Neutral peripherals, in which we prefer Portugal & Ireland to  Italy & Spain

The non-core European bond markets continue to be supported by the ECB; flow dynamics, too, are positive. Investor-positioning, furthermore, remains close to record lows. 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, political risk remains ripe. While the initial quest for independence in Catalonia was smothered by Madrid, the subsequent elections in the region have been encouraging for the separatists, who are continuing to fight to keep their campaign for a Catalan republic moving forward. Furthermore, the Italian parliament has been dissolved and the country faces general elections in March. The latest polls indicate that no party has a clear majority and there is significant uncertainty over who the main protagonists of a probable coalition will be. In any case, the formation of a government is likely to be a protracted and tedious process. In this context, we have a slightly more favourable view on Portugal and Ireland, both countries having been upgraded by Fitch on the basis of improved financial conditions and reduced debt costs. On the other hand, we are cautious on Spain and Italy, and our overall outlook on peripheral sovereign bonds is neutral.


Exposure to US, Canadian and Japanese Break-evens

The overall framework for inflation-linked bonds continues to point upwards, asthe favourable inflation cycle and model balance out a tepid carry (negative in the US). The asset class performed better last month, especially in Japan (where there is room for a better performance on break-evens). The inflation cycle faces upwards pressure going forward. Valuations also continue to be attractive while our break-even model momentum model is positive on US, Canadian and Japanese linkers. In the UK, on the other hand, valuations remain expensive. In this context, and in spite of some caution on the carry, we hold a favourable view on break-evens in the US, Canada and Japan, while having taken profits on Euro linkers.