Bond market dynamics in the next months: negative territories for how long?

1. EDITORIAL

As we described in the last number of this newsletter market volatility is to be watched out actually as the catalyst of the last part of the year are fast approaching.

The catalysts for the global markets will be the US presidential Elections (8th November), the Italian Referendum (4th December) and, last but not least, the December ECB Meeting (8th December).
Especially the Italian Referendum could have substantially impacts on the Italian Government’s ability to introduce further reforms. Investors in this case will face either a positive or a negative scenario that could induce volatility onto the markets.

Some investors who do not want to gain exposure to the equity markets should invest on the bonds markets but with after very careful consideration of the dynamics on these markets as well especially following the changes induced in the last years by the monetary policies put in place by the Central Banks at a Global Level.

Bonds as an asset class have performed extraordinarily well for many years, and anyone who called for rising yields and negative bond returns was proven wrong year after year. Now, risk-free yields in most major developed markets are either below or close to the zero line.

At the beginning of October, 40% of global developed market bonds traded at negative yields. In the Eurozone it was 60%, in Japan 76% and in Switzerland 95%. In addition, more than 80% of the EUR covered bonds and agency bonds analyzed traded at negative yields, and even more than one third of the senior corporate bonds.

If you look at Figure 1 you can see the curves of different Government bond in different currencies: EUR (Green), CHF (Blue), USD (Red), JPY (Orange) & GBP (Yellow).

Figure 1: Sovereign Bonds Curves

Of course yields can go down some more, for example reflecting fear of deflation, but the recent decline in the marginal impact of further central bank easing on bond yields suggests that only few captive investors still join the central banks in buying at deeply negative yields. Even if rates were to remain unchanged, many shorter to medium-term bonds would deliver negative total returns.

Investors who avoid negative yields and instead buy longer-dated paper at a slightly positive yield often take an even greater risk. We believe that the consistently lower-than-anticipated inflation in recent years and the long-lasting decline in bond yields has resulted in widespread investor complacency about duration risk.

The sensitivity of total returns to changes in yields is mainly driven by the bond’s remaining term to maturity – the further out the repayment of a bond’s nominal, the stronger the impact of a change in the discount rate (i.e. the yield). However, as our screening considers potential 12-month total returns, the amount of the carry yield and the shape of the yield curve matter as well.

The carry yield is the income accrued over a period – the higher the carry, the greater the buffer against losses resulting from rising yields. If the yield curve is upward sloping, the discount rate for a shorter-term bond is lower than for a longer-dated one – the steeper it is, the greater the difference. If the shape of the yield curve remains unchanged over the period, a lower discount rate results in a higher value of the bond, all other things equal, which is called the curve roll-down effect.

Yield curves are currently relatively flat in most major currencies (see again figure 1 for this evidence). Higher long-term inflation expectations would most likely lead to a steepening of the curve, because the short end would remain fairly anchored by the monetary policy rates and the long end would increase. Figure 2 reflects the Inflation Expectations for US (Blue), EU (Orange), UK (Green) & JAP (Purple) markets.

Figure 2: Inflation Expectations [Inflation SWAP Forward rate 5Y5Y]

Investors should look to quality into the bond markets as the yields, as previously stated, had run too much into the negative territory. So maybe the odds for a bond market crash could raise significantly in the next months.

Evidence is given also from credit spreads that widened significantly especially for US and European High yield bonds (by 18 and 8bps respectively), while the emerging market (EM) government bond market proved resilient – credit spreads widened by only 3bps.

Since then, global yields and volatility have declined after the Fed voted to hold any rate hike due to mixed macroeconomic data. Beyond monetary policies, other factors can be important catalysts for a bond market crash.

Four main risk factors could be seen as these catalysts onto the bond markets:

1. an unexpected acceleration of growth rates and inflation
2. unsustainable debt trends
3. credit demand and investment pick up
4. an acceleration of China’s economic growth and new flows on the markets

Figure 3: Bonds Indices [Bloomberg Barclays Indices [Global Aggregate (Blue), US Aggregate (Orange), Euro Aggregate (Green), Emerging Markets HC (Purple)]

Cristian Rusconi

2. DATA TO WATCH

US

• 11th October: NFIB Small Business Optimism
• 11th October: Monthly Budget Statement
• 12th October: MBA Mortgage Applications
• 13th October: Import Price Index MoM & YoY
• 13th October: Initial & Continuing Jobless Claims
• 14th October: PPI Final Demand
• 14th October: Retail Sales Advance MoM
• 14th October: Univ Of Michigan Sentiment
• 17th October: Capacity Utilization
• 17th October: Industrial Production
• 17th October: Empire Manufacturing
• 18th October: CPI MoM & YoY
• 18th October: NAHB Housing Market
• 19th October: MBA Mortgage Application
• 19th October: Housing Starts & Building Permit
• 20th October: Philadelphia FED Business Outlook

EU

• 111th October: ZEW Survey Expectations [EZ] & ZEW Survey Expectations & Current Situations [GER]
• 112th October: CPI MoM & YoY [FRA]
• 112th October: Industrial Production MoM & YoY [EZ]
• 113th October: CPI MoM & YoY [GER]
• 117th October: CPI MoM & YoY [EZ] & Trade Balance Total & EU [ITA]
• 120th October: PPI MoM & YoY [GER]
• 120th October: ECB Rates Decisions
• 124th October: Markit Manufacturing PMI, Services PMI, Composite PMI [EZ & GER]

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