Iggo's insight: a view from the bond market - commentary from Chris Iggo, CIO Fixed Income, AXA IM

Chris Iggo

Investor sentiment has changed. At the very least people are questioning whether the “lower for longer” view on interest rates is still the right roadmap. Donald Trump potentially changes that to a “boom and bust” scenario, at least for the United States. Growth, inflation and interest rates are likely to be higher. It is not clear how it impacts the rest of the world but normally US reflation lifts many boats. For bonds, despite ongoing dovishness from central banks, the light at the end of the “unconventional monetary policy” tunnel is starting to appear. Bond risk premiums will rise. Bond returns are in a slump as markets transition. The question is whether the Trump boom has a more prolonged impact on yields than the taper tantrum of 2013 or the Bund shock of 2015. The chances are it will.

Boom, bust and beyond

It’s been a while since I had the opportunity to write this note and quite a lot has changed in bond-land. Yields are higher and the worldview has changed from the prevailing “lower for longer” view of interest rates to “boom, bust or both”. Prior to the US election the view had been that nothing much was going to change in the economic outlook for the major economies with 2017 GDP and inflation forecasts not materially higher than the estimates for 2016. This meant that central bankers would have had little choice but to stick with their low rate and balance sheet expansion policies even though it seemed there was diminishing marginal effectiveness.

What was missing from the outlook was a reason to doubt the “secular stagnation” argument – a situation characterised by insufficient aggregate demand, weak productivity growth, balance sheet constraints and lousy demographics. With each false start, bond market bears were losing confidence in there ever being a sustained increase in the level of yields. The bond risk curve had been flattened by monetary policy to the extent that the overwhelming technical force impacting on bond markets was the search for yield – investors could go longer on the curve and deeper down the credit universe without fearing either an increase in rates or systemic credit deterioration. The central bank put has been extremely effective.

Fed Funds higher in 2017

Then along comes Donald Trump and his promises to cut taxes and boost spending. Whether he can deliver or not does not really matter yet because it is the risk that he can that is driving things. If he provides a fiscal boost to an economy that is already operating at full capacity then the likelihood is that inflation and interest rates will be higher. The risk of dis-believe was too great given the asymmetric return outlook for a bond market already operating with yields close to all-time lows. The reaction has been spectacular. The US Treasury 10-year yield is up 55 basis points (bps) since the day of the election, the 30-year yield is 40 bps higher and the S&P500 is up 6.8%.

A Federal Reserve (Fed) rate hike next week is a done deal and expectations of interest rates in 2017 and 2018 are much higher now than they were on November 7th. At least one bank is forecasting that the Fed Funds rate will be at 2.0% by the end of 2018 – taking it back to zero in real terms if inflation continues to rise. I am not sure that the bond market has fully priced in the implications of the main policy rate being increased by 150 bps in the next two years. This won’t be a 1994 rout but it could just be as painful for those investors that have locked in to low yielding assets in recent years.

To me there is a great risk of under-estimating the potential upside risk to growth and inflation that comes from a new Administration that appealed to voters because it was going to do all it can to boost economic growth and incomes. There have been many calls for using fiscal policy to break the back of the post-crisis malaise and this appears to be what is now going to be happening in the United States.

Reflation first?

We held our quarterly strategy review earlier this week and our conversations with economists and strategists suggest that the consensus has shifted markedly towards expecting a stronger US economy next year. Of course there is little clarity on Trump’s plans and there are concerns about protectionism being a negative global force, but generally the view is for stronger growth and higher inflation. However, the outlook is nuanced. For one thing the delivery on growth boosting policy might fall short of expectations. Secondly, higher inflation will eat into real income growth and thus weaken consumer spending. Thirdly, financial conditions will tighten (stronger dollar, higher bond yields, higher mortgage rates) and this will contribute to a slowdown.

In my mind to get to the bust we first need the boom so I expect rates and yields to move higher and credit spreads to widen at some point. It is quite feasible though, to have a boom and bust within the confines of Donald Trump’s term of office. It seems redundant to say that volatility, especially in rates markets, is likely to be higher in the next year or so. Interesting that equities have demonstrated a fairly unequivocal response to Trump’s victory with the Dow Jones Industrial Average posting several record highs since the election.

Higher equities, strong employment growth, lower taxes and targeted government spending should temper the tightening of financial conditions. It also has to be said that the Fed is yet to respond in terms of its outlook but recent form suggests that it will be reactive rather than proactive in tightening monetary policy.

Not tapering, honest

If US growth is going to be stronger, what about the rest of the world? Stronger growth, higher equity markets, a weaker euro – should this not be positive for the euro area? It seems that this is not the view amongst most economists so far. Indeed, it does not seem to be the European Central Bank’s (ECB) view either, which announced this week that it would continue with quantitative easing through to the end of 2017. The run-rate is going to be reduced to €60bn per month from April onwards (from €80bn) but the total balance sheet expansion remains considerable. Moreover, the ECB changed the mode of operating in the market slightly to allow it to purchase bonds with a remaining minimum maturity of 1-year (from 2-years) and to be able to purchase bonds with a yield to maturity below the interest rate on the deposit facility (-40bps). This should keep short term rates very low and should mean a steeper yield curve in Europe.

Draghi was at pains to argue that the changes did not herald any kind of tapering of quantitative easing (QE) and that the macro outlook was still not strong enough to justify that. But surely Europe will reap some benefit from a stronger US? At any rate, there is a sniff of tapering in the air and this should prevent bond yields from re-visiting the lows of earlier this year.

Politics remains a source of risk

The cautiousness on Europe is perhaps more explained by the political outlook and the potential for more damage being done to the European project in 2017. At some point next year Article 50 will be triggered by the British government with all the political and economic uncertainty for the UK that will bring. Then we have elections in France, Netherlands and Germany. While the economy in the euro area could potentially be stronger, there are clear threats from political risk.

However, I suspect being underweight European equities will, on the whole, be the wrong trade in 2017. In bond world that means high yield and credit probably do alright on a relative basis but with very limited upside for return. Then there is Italy. The defeat of the proposed constitutional reforms in the referendum last weekend barely impacted on markets, which I find interesting in that it may tell us that the ECB is everything in Europe (hence the lengths to which Draghi went to say it was not tapering). The reality is that reform in Italy is delayed even more and that means growth will remain very disappointing. The OECD expects nominal GDP growth to be less than 2% in 2017 and borrowing costs might rise above that level. The implication is that the debt dynamics remain pretty poor and could get even worse if the public sector is forced to find a solution to the bank capitalisation problem. Bailing in bond holders in the Italian bank sector would be very difficult politically because of the large number of retail holders, but it may be necessary in the absence of external capital support.

Imagine bailing in or hair-cutting holders of Italian government debt. It seems unthinkable and it probably is a distant tail risk at this time given that Italy is self-financing (current account surplus, high household savings rate), but investors need to ask the question as to whether a yield of 2.0% for 10-year Italian government debt is the right level of reward. Tapering will come in 2018 and even if official policy rates in the euro area remain unchanged for years to come, bond yields will adjust higher at some stage.

So we can list lots of reasons to be negative on Europe and the more bearish investors will see the potential for European problems to spill over on to the global stage. It is worth noting that the two post-crisis lows in US 10-year Treasury yields coincided with European problems – the crisis in 2012 and the Brexit vote this year.

Emerging markets – part of the reflation trade?

The outlook for the US has mixed implications for emerging markets. Of course the knee-jerk conclusion is that Trump is bad for emerging markets because of things he has said about Mexico and China and the general protectionist tone of his comments about global trade. The reality is the US is a current account deficit country and that is nothing to do with free trade or unfair practices. It is about the US being a destination for capital inflows (in large part to finance its government budget deficit) and competitiveness. Restricting imports to the US through higher tariffs or quotas might impact trade in certain goods and services but at the macro level it will be a negative for US consumers (less choice, higher prices) and may be met with retaliatory action from trading partners (so negative for US exports).

In reality I suspect that rhetoric will not be the reality and punitive trade policies from Washington will be relatively limited. So for emerging markets there is the prospect of stronger US growth (a major destination for consumer goods) and higher global commodity prices. That should be positive. The negatives are a stronger dollar which creates inflationary pressures in emerging market economies and can add to debt pressures. From a bond investor point of view a stronger dollar and upward pressure on local rates would be something of a re-run of 2013, and for investors in dollar denominated external debt the question is how much higher Treasury yields can impact on sovereign and corporate spreads. So far, so good with the spread on the hard currency sovereign debt index almost back to pre-election levels. Interesting that in our discussions this week, Russia came out as the top pick amongst the larger emerging market names – recovery from recession and higher oil prices being the drivers of improved sentiment.

There is also the chance of sanctions being lifted depending on how political change in the US and Europe improves relations with President Putin. In summary, with an extra 380 bps in a portfolio of sovereign emerging market USD debt and improved macro conditions in many emerging markets, this is an asset class that fits more in line with the reflationary impulses that are currently lifting markets.

Risk on

Bond yields have been depressed because of monetary policy in recent years and this became the zeitgeist because of the lack of any visibility of success in the fight against deflation. Yet the US has been slowly moving into a reflationary phase and the election of Trump will magnify that trend. Bond returns are determined by what happens to interest rates and credit spreads. My view is that rates were too low to compensate investors for the risk of higher rates in the future and so we are going through a transition period that will see yields move back to more normal levels.

For credit, the key is economic growth and corporate earnings so for the time being you will be rewarded for taking credit risk given that spreads are above the tightest levels they reached in 2014. However, in investment grade markets the rate component will overwhelm the credit return. The positive strong growth argument also supports equities. So underweight rates and overweight risk. The caveat is that things can change quickly and, heaven knows, if 2016 is anything to go by the future can be very unpredictable.

That was THE year that was

It would take hours to do full justice to a review of 2016 with all its trials and tribulations, political earthquakes, celebrity deaths and long-shot football victories. What have we learnt? Voters don’t like the centralising tendencies of government. Social media trawling big-data analysis provides better predictions than opinion polls. Politicians don’t always tell the truth. The immortality of great music does not mean the immortality of great musicians. In football, being “special” is not a permanent thing. There will be far more eloquent pieces written about 2016 as the year-end approaches so plenty to read as you spend time with your families over the holidays.

In the UK the one bright spot was sport – a huge medal haul for Team GB at the Rio Olympics, Andy Murray winning Wimbledon, the Davis Cup and ending the year as the world number one, and Danny Willet winning the US Masters. Choosing the BBC’s Sports Personality of the Year will be a very difficult task. The England team didn’t let us down in the Euros, losing to lowly ranked Iceland (not to mention losing two managers since that evening in Nice). For me it was another disappointing year for Man United but I look forward to better things in 2017 now that the Armenian fellow with the difficult name has started to turn on the style.

Happy New Year (fingers crossed)

So bring on 2017. Bond returns will be in transition. As is usual, much of the sentiment and volatility in bond markets will be driven by what the central banks do. In the absence of any kind of downside economic shock they won’t be easing any more. For Yellen’s Fed it is all about responding to late-cycle fiscal stimulus. For Draghi it is about prolonging the denial that tapering is coming for as long as possible. All in, it means steeper yield curves and wider inflation premiums. How much confidence do I have about those predictions? Come on, after 2016 I’m not forecasting anything!