Navigating the sovereign bond landscape
- Without a material shift in the economic/monetary/trade backdrop, we look set for lower yields
- Wary of being too long on duration. Crowded positioning and higher rates volatility are risks
- EM Asia sovereign bonds have rallied on lower US rates, rather than compression of risk premiums
- External environment turning less supportive. Outperformance of high-yielders may fade
- Implications for investors – Favour shorter tenors in sovereign bonds
High levels of caution in markets
While central banks can certainly boost asset prices in the short term, their ability to support and turn around the growth outlook (by extension, lead to higher asset prices over the longer term) is increasingly being questioned by markets. Beneath the surface of high equity valuations and tight credit spreads, market confidence is weak. In interest rates, despite the recent bout of monetary easing across the world, curves have not steepened and inflation expectations (market-based) remain depressed. In FX, the USD remains strong against EM currencies despite declining interest rate support. In credit, lower-yielding US investment-grade have been outperforming high-yield bonds.
Falling yields and flatter curves?
With global economic data trending weaker and possibility of a US-China trade deal looking remote, markets just keep pricing for more severe economic scenarios (which would also require central banks to ease even more). Investors keep buying sovereign bonds, both short tenors to position for monetary easing, and long tenors for portfolio protection. These forces can be difficult to overcome unless there is a material shift in the economic/monetary/trade backdrop. Below, we list the top 5 possible events that could drive yields higher and curves steeper:
1. Re-acceleration in global growth
2. Upside surprise in inflation
3. Significant fiscal stimulus
4. US-China trade deal
5. Central banks under-deliver against easing expectations
At present, the likelihood of any of the above events materializing appears to be low.
1. Recent global economic data have been poor and continue to point to a deeper slowdown.
2. Inflationary pressures remain subdued and falling oil prices are not supportive.
3. Within G3, Europe has the most room for fiscal stimulus. However, German officials are reluctant to expand spending while other governments are unlikely to do much given the budget rules of the bloc.
4. Chances of a US-China deal have been falling with recent escalations on trade and currency fronts.
5. Last week, several central banks delivered rate cuts that were either larger than expected (India, New Zealand, Brazil) or very much against consensus (Thailand). These decisions could be part of a broader trend by global central banks to actively surprise the market, so as to provide a greater boost against greater downside growth risks.
Favour shorter tenors in sovereign bonds
Though sovereign yield curves could move lower and flatter in the short term, we are wary of being too long on duration. Based on latest fund manager surveys, long duration (especially via US Treasurys) has become an extremely crowded trade and we are concerned that any reversal could be quite sharp. Most importantly, interest rate volatility has surged recently and could stay elevated around news flows on US-China and Brexit developments. The wide dispersion in markets' perception of forward Fed path could also be another source of volatility.
Therefore, we think the risk-reward for taking greater duration risks via longer tenor bonds (10Y and beyond) may be quite poor. Instead, shorter-tenor bonds (up to 2Y) could offer better risk-adjusted performance. With central bank easing bias firmly in place, shorter-tenor yields are likely to be more anchored.
EM Asia: less support for high yielders
Focusing on EM Asia sovereign bonds, the broad rally has been primarily driven by lower US yields rather than compression of risk premiums. In fact, spreads to US Treasurys, proxy for risk premiums, are wider except for Philippines (again, suggesting high investor caution). Broadly speaking, we think EM Asia sovereigns can continue to perform well. Increased prospects of Fed and ECB easing would give Asian central banks the cover to cut rates without much worries of depreciation pressures on their currencies, especially for high-yielders.
We are wary however that the outperformance of high-yielders (PH, ID, IN) vs low-yielders (KR, SG, TH) could reverse. Both fixed income and FX returns of high-yielders have disproportionately benefitted from the global reach for yields this year. The risk is that sentiments deteriorate ahead, either due to deepening of global slowdown or further escalations in US-China tensions. In that scenario, investors' yield-seeking appetite and hence, support for Asia high-yielders could fade.
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