The Bond Market Can Finally Do Its Job Again

Calm has broken out in the bond market, but the respite is likely to be brief.

It’s a question of when — not if — the 2% bound will be breached on the 10-year U.S. Treasury yield. That’s directly correlated to last week’s revisions to the non-farm payroll series; it shows the pandemic recovery has been both smooth and strong. If growth is more robust, inflation will be, too. This rise in yields is a global trend, forcing central bank thinking to shapeshift.

None of the market gyrations adds up to a rout: The speed of the fixed income selloff is relatively broad and orderly. That makes it more likely to be sustained than a brief overreaction. It’s the bond market’s job to send warnings on inflation, but the function was smothered by all the QE bond buying this past decade.

The current shift higher has been driven by real yields — that is nominal yields minus inflation — because there is a fundamental rethink of how high the price gains will be in the next few years. TIPS — that is, 10-year U.S inflation-protected Treasury bonds — have gained 60 basis points this year already. This shows that the market believes central banks have come around too late to control inflation. Up to Tuesday, German bund yields rose for 11 sessions in a row, gaining 35 basis points, the worst streak since unification in 1990.

None of us has a crystal ball, central bankers included. After all, it was their stimulus programs — amid chip, logistics and energy price shocks —  that allowed inflation expectations to become embedded. The Federal Reserve — which isn’t done with stimulus — is doing a fine job talking the markets into believing it will get a handle on inflation. Many market commentators took away an avowedly hawkish message from the last FOMC press conference and statement, but the key word Chair Jerome Powell used was “nimble” — which surely means reacting to data shocks in either direction, not just a baked-in series of hikes.

As the worst of the inflation surge is probably over, future bond yields (and thereby equities) are likely to react to the strength of the economy rather than historic inflation gauges. Pay attention to forward growth indicators and how the Fed reacts to them.

It is logical that credit spreads — the premium that corporations pay above government benchmarks — have turned up from a very low base. If yields are heading higher overall, the bond space is going to experience asset reallocation. For instance, peripheral European sovereign credits have performed worse than investment grade companies because that’s where there’s been a necessary repricing of risk.

In Europe, investment grade spreads are close to the 10-year average — a period that spans the euro-zone debt crisis, the 2016 commodity jitters, the 2018 Italian crisis and the pandemic itself. The rise has been relatively sharp with February already one of the worst months in terms of spread-widening in years: 98% of of the euro investment-grade index is wider this year. Some of this may be an overreaction to a perceived sudden change in European Central Bank thinking on continued stimulus.

On the plus side, global default rates — admittedly a lagging indicator — show no signs of turning upward. That is largely because all that fiscal stimulus means there is little chance of a recession. Corporate access to funding in recent years has also been plentiful: Most have drunk long and hard at the well and are funded at super-low rates for several years. U.S. corporate spreads should benefit from the foreign buyers attracted to the red hot American economy, according to JPMorgan Chase & Co. analysts.

Nonetheless, bonds overall are destined to underperform as underlying government yields are rightsized to the post-pandemic economic and inflation upswing. Hedging tail-risks becomes more necessary. Credit remains a relatively safe space. The supply of new debt may moderate, acting as a natural balancer until more attractive yields lure back investors. For now at least, book sizes on European and U.K. sovereign deals remain very healthy, with Spain’s new 30-year on Wednesday seeing orders nearly 10 times the 7 billion euros ($8 billion) raised.

Italy’s spread to Germany may be at the widest since summer 2020, but it is probably more of an investment opportunity than a warning signal. The fundamental backdrop for the third-largest European economy is a lot stronger than it was during the May 2018 sovereign crisis that saw 10-year BTP yields double in short order to over 3.5%. They have risen 120 basis points since summer but are still only at half of the 2018 extremes. It helps that the political hiccup over the presidency has been resolved for now: Mario Draghi remains prime minister; there is no Italian crisis.

The ECB is set to buy the entire 60-billion euro net supply that Italy issues this year. With those higher yields, Japanese buyers might be tempted to diversify from the still mostly negative-yield German bunds — a trend many others are pursuing.

Bonds are now somewhat akin to equities, becoming more of a stock picker’s market. There are bargains for those committed to the asset class. But it will be heavy lifting until inflation disappears or growth falters.

Πηγή:bloomberg.com