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- Rates must remain low
- Abundance of supply in government and corporate bonds equals increased leverage
- Leverage is not the concern, but interest cover is
All of the current conditions point towards a quiet summer for rates markets with an exceptional degree of monetary accommodation and improving market sentiment. Despite the expected rebound on the macro side, there is not enough improvement to kick off a more pronounced move higher in yields.
Yields are very close to historic lows, but ongoing monetary stimulus will limit the magnitude of any sell-off. The macro risk posed by a second wave of infections is most definitely on the horizon for the majority of investors. While there is a broad agreement that the containment measures are going to be more limited and localised, there is a view that the impact will be mostly felt in risky assets, with a more subdued rally in fixed income given the fact that bond yields have been in a tight range over the last few months. In this environment, characterised by low rates and low volatility, we would expect carry trades, such as the Italy 10-year bond spread relative to the 10-year German bund to perform relatively well.
Bond supply is plentiful on both a government and corporate level. As of June 2020, according to the IMF, the global fiscal support in response to the virus crisis stands at around $9tn or 12% of global GDP ($76tn at end-2019 exchange rates). This implies that, at a global level, after also factoring in a decline to GDP by 5% this year, the government debt-to-GDP ratio would increase from around 88% at the end of 2019 to 105% by the end of this year. At a global level, the private sector, i.e. household and non-financial corporate sector, debt to GDP ratio would increase from around 155% at the end of 2019 to 173% by the end of this year.
Adding $16tn of additional debt this year would raise the total debt in the world, private and government debt, to a new record high $200tr by the end of this year raising the total debt to GDP ratio for the world as a whole by around 35 percentage points, from 243% at the end of 2019 to 278% by the end of this year. This 35 per cent of GDP increase in global indebtedness is even bigger than the 20% of GDP increase seen in the year after the Lehman crisis in 2008.
The main implications from the big increase in global indebtedness are key as to why yields on offer will remain low for a considerable period;
- The private sector would likely be inclined to save more in the future, sustaining the persistently high savings rates seen in the decade after the Lehman crisis. In turn, persistently high private sector savings rates would keep economic growth and inflation low and make it even more difficult for debt levels to decline vs. incomes in the future.
- Very accommodative central bank policy policies and low interest rates are likely to continue for a very long time to make it possible for both the government sector and the private sector to sustain their much higher debt levels.
Having injected over $3tn in liquidity over the past three months, in the last weeks of June, there was a decline in the balance sheet. One may be inclined to think that the Fed is looking to maintain its balance sheet at current levels as the market turmoil has subsided. However, the US Investor base (now that foreign investors have hit the brakes on US Treasury purchases), will be on the hook to fund the $1.6tn needed to bridge the full amount of US funding needs. With real yields for 10-year bonds at around -0.9%, there is little interest from investors (domestic and foreign) to own these bonds apart from a safety angle. What is more likely, is that the Fed will need to monetise more debt – about $1.6tn more than it currently envisions in order to avoid a disorderly surge in Treasury yields.
The $3tn increase has been funded mainly by T-Bills, which has meant that this new debt is cheap in interest terms (less than 20bp) and as such despite the massively leveraged balance sheets, its actual interest expense remains lower than before the Covid-19 crisis. This poses a potential trap that has been set by the US Treasury for the Fed to force them to keep rates low, until the Treasury either terms out this increased $3 trillion of debt or pays it back. Any increase in rates will have a detrimental effect on the US Government interest expense allowing the US Government to sustain its debt pile. Not only does it aids the government but the persistent low interest rates will bail out many lower-quality companies (helping the Fed with its goal to limit the cyclical and structural damage to the labour market) by allowing them to borrow aggressively and continue to rollover debt. Confidence is the holy grail of sovereign debt markets and it is important for the Fed to ensure that investors do not doubt the US ability to meet it debt obligations.
Whilst this supply does pose a potential supply overhang risk for higher yields, it is offset by the other outlined factors and as such we see the conditions created for a persistent low rate environment going forwards. As it is, the Federal Reserve has indicated that it is concerned about prospects for the US economy, with speakers warning about the on-going risk of a financial crisis, and against a premature withdrawal of easing measures in place to prevent it. The timescale for any given “normalisation” was hinted by the latest Fed minutes that discusses a four-year recovery path, even with a successful virus vaccine discovery scenario, gives us an insight into this. This provides confirmation of our stance that “low yields” is the investment environment we will find ourselves in for the short and medium-term.
The Fed has made it clear that some form of Yield Curve Control is in existence as it has reiterated that it would keep rates at zero and continue to buy bonds ‘for many years’. As such, the market will keep yields range bound with potential steepening seen in the long end of the curve. Our medium-term view does see an eventual move into the 75-100bp range for the 10yr, but this is more a post summer move, and really needs better health news for it to come to fruition. In the meantime, the range is 54bp (all-time low) to 70bp, and the possibility of taking aim at that prior low is not over yet.
With the risk reward ratio for holding government bonds terrible, due to the lack of a yield we prefer to be underweight in US government bonds and prefer to own solid IG rated companies which benefit from not only the low rate environment but also the support provided by the Fed through its Primary Market Corporate Credit Facility (PMCCF) for new bond and loan issuance and the Secondary Market Corporate Credit Facility (SMCCF). In High yield, we note that there is yield on offer but prefer to be selective in our name selection noting that the damage to the economy / main street will cause repercussions to various HY sectors. Overall, in Credit our preference is for US Issuers BBB rated bonds given that they provide a real yield after inflation and level of implicit support from the Fed.
Supportive actions and comments for the sovereign market from the ECB (including an increase in the Pandemic Emergency Purchase Program (PEPP) and addressing the German Constitutional Court’s ruling on the Public Sector Purchase Programme (PSPP)) have benefitted periphery government bonds the most. We do wonder that if the ECB’s aim is to take inflation back to the pre-COVID levels, then the expansion of PEPP will continue for much longer and potentially larger in size than currently expected.
Despite some inflationary pressure in some pockets of the economy due to some price mark-ups, the overall picture with high unemployment, increased uncertainty and the risk of companies going out of business is clearly disinflationary. The economic outlook for the eurozone is simply too uncertain. Negotiations (and the eventual decision) on the European Recovery Fund have to be finalised and could also have a further tightening impact on bond yields.
While the ECB’s Olli Rehn and Phillip Lane have spoken against explicit yield targets, we do note that a key target of PEPP was to lower the yields on European government bonds (as measured by the GDP-weighted 10Y yields). There may not be an explicit target for individual countries but it is fair to conclude that average yields should remain below pre-PEPP levels for the program to be successful. With most of the core countries offering negative yields, we prefer to hold Italy (where we note that the central banks are absorbing all projected supply for 2020) and Greece, where we believe the spread to German bunds will continue to compress back to pre-PEPP levels and offer a modicum of yield along with IG rated bonds.
10-year gilt yields are close to their historical lows however, on-going monetary stimulus sentiment will limit the magnitude of any sell-off. Despite comments from the Bank of England regarding the potential exit strategy from the monetary stimulus, it is still far too early for the gilt market to contemplate any unwind of the balance sheet. Brexit negotiations have restarted with impasse on level-playing field commitments still needing to be ironed out.
We expect ongoing Brexit uncertainty as discussions progress with limited visibility on the potential deal, adding to the headwind facing the UK economy.
The UK chancellor has also announced further fiscal stimulus to boost the UK economy, but while the size of the stimulus announced is modestly larger than expected, It is designed to kickstart the economy (and retain jobs) than significantly alter the UK growth outlook. With low yields in the government bond market offering little carry (or potential for price appreciation), we continue our strategy of favouring IG rated global issuers much like our strategy in the EUR and US markets.
Past performance is not a reliable indicator of future returns. Forecasts are not a reliable indicator of future returns. If the information is not listed in your base currency, then the result may increase or decrease due to currency fluctuations.
If not otherwise indicated, all graphs are sourced from Dolfin research, July 2020.
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