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All Quiet on the Fixed Income Front – For Now

After a 30-year bull market, fixed income investors are now staring down the barrel: 2017 could be the year the government bond bubble finally bursts. It’s no time to be blithely banking on bonds.

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The end of an era

President Trump’s efforts to ignite the US economy through massive infrastructure spending and tax cuts could herald the end of the era of secular stagnation and deflation. His fiscal push could force headline rates higher than many expect.

And yet it remains quiet – possibly too quiet – in the bond markets. Although higher, current US Treasury yields – as of 16 March they were around 2.52 percent – suggest people are expecting the kind of monetary policies that have suppressed yields since the global financial crisis to persist. Those yields can also suggest a belief that President Trump’s economic measures will fail.

Neither of those two scenarios seem likely. In fact, most macroeconomic indicators are already suggesting activity is improving, even though most of the big-ticket reforms are yet to materialise. At Lyxor, we expect the US economy to grow by around 2.5percent this year, slightly above consensus estimates. A slight caveat – there are some bearish signals, too.

What does this mean for yields? The Lyxor Cross Asset Research team believe there’s a 50 percent chance 10-year US yields will reach 3 percent by the end of 2017. But we also see a 40 percent chance of them surpassing 4 percent. Conversely, should campaign promises not be kept and the economy struggle, yields could plunge to around 1.5 percent. But we believe there’s only a 10 percent chance of this happening.

Big implications

US yields have big implications for European investors, as US Treasuries and G9 government bond yields tend to move in tandem when bonds are selling off. This was indeed what happened in Europe after the US election. Many in the market assumed the sell-off was overdone, but in Lyxor’s view those participants are yet to adjust to the new reality.

Policies are changing almost daily in the US, so further sell-offs can’t be ruled out. The Fed has, however, learned its lessons. The .25 percent hike in March was signalled loud and clear ahead of time, so its immediate impacts on the markets were limited. Much depended, instead, on the path ahead. By sticking to its expected normalisation path – five hikes between now and the end of 2018 - the Fed signalled it intends to stay “behind the curve” to help build growth momentum.

Whether it can join those dots in a world so leveraged to the dollar, and so sensitive to US borrowing costs, remains to be seen. The Fed may have to be the world’s central bank for a while yet.

Europe in the firing line

With valuations looking rich, eurozone bonds are firmly in the firing line and looking more precarious. We believe a taper before 2018 would be a mistake, but investors do need to prepare for ECB life support to be turned off.

If the bank were to taper this year – some observers are predicting a EUR 20 billion cut in its Public Sector Purchase Programme in September – things could get worse for fixed income investors, as such a cut is not being priced in. Rate rises still look a more distant prospect, despite recent speculation.

For now, political risk has kept a lid on yields, but the forthcoming elections in France could change that. The Dutch election result soothed some nerves, but investors should tread – and trade – carefully amid political uncertainty, and what are likely to be more volatile country spreads. A prudent approach to duration may also be warranted.

Caution is also advisable about peripheral euro sovereign debt should bond yields rise generally, and ECB support fade. Uncertainty in Italy won’t go away soon and there may be more trouble ahead for Greece. At Lyxor, we recommend concentrating on the core and playing the politics, not the economics.

Brexit could also play a part in bringing to an end the bond party. The prospects of a “hard” Brexit continue to keep sterling depressed, and will eventually feed through to higher prices, leading to rising inflationary pressure. With no more Bank of England easing in sight, and the latest tranche of quantitative easing coming to an end, the outlook for conventional UK gilts is neutral at best.

Know your credit limit

After a good 2016 for credit, it’s difficult to be too optimistic this year. Spreads will widen as general bond yields rise. In fact, if spreads properly reflected political risk, they’d already be much wider than they are now.

The next few months could be difficult for European credit investors if political risk is as badly mispriced as some fear, although the ECB’s corporate sector purchase programme does provide some support. However, other assets look likelier to be hit first should the ECB taper. Healthy corporate fundamentals, a low default rate, and a more robust banking sector also provide some respite.

After the party

So what should investors do if the peace in the bond markets is finally shattered? Put simply, it’s about using all of the tools at their disposal.

Tactical trading may be important with bouts of volatility rocking today’s relatively illiquid fixed income universe. Hedging with linkers, breakevens and floating-rate notes could help as reflation kicks in and rates start rising. Look to short-dated or high-yield bonds to reduce rate sensitivity, and use shorts to protect against, or exploit, downturns. To help investors, Lyxor offers investors a more complete toolkit than other ETF providers.

Disclaimers:

All data: Lyxor Cross Asset Research & SG Research, March 2017. Opinions expressed are as at March 2017.

This communication is for professional clients only.

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