Bond market shoots first, asks questions later

By:
Louise Bowman
Published on:

The election of Donald Trump prompted a vicious sell-off in global bonds. Investors face the new year with warnings over volatility and inflation ringing in their ears. Will it be as bad as they think?

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Working in the bond markets can be pretty exhausting. If a burned out trader had decided to take a year-long nap on December 1, 2015 with the 10-year US treasury at 2.24%, he or she would have woken up on December 1, 2016 with the UST 10-year at 2.34%. So, nothing much happened last year, right?

Wrong. So much happened it is hard to know where to start. While our bond trader was sleeping, the UST 10-year hit an all-time low of 1.50% in July 2016, the UK voted to leave the European Union and the US elected a reality TV star as its next president. With this as the backdrop, looking forward into 2017 is a fool’s errand – quite clearly anything can happen.

By mid-December, the global aggregate bond index had lost $2.4 trillion of market value since Trump’s election, suggesting that his proposed fiscal stimulus will translate into almost immediate growth and inflation.

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Arvind Rajan,
PGIM Fixed Income

"It is hard for the markets to price in the protectionist agenda, so they have priced in Trump without the bad stuff," says Arvind Rajan, head of global and macro at PGIM Fixed Income in New York. 

"A big dose of humility is in order here," he adds. "When rates have moved so far and so fast you have to respect that. But the market seems not to be thinking about tails. It is clear when you look at the VIX near record lows that these are not being recognized. There is a fat deflationary left tail to all of this and if there is a supply-side shock to commodities – that could introduce right tail risk as well."

The bond market rout rolled on throughout December and a 25bp rate rise by the Fed was fully priced in by mid-month. While the Fed is likely to continue hiking in 2017, the bond market reaction to Trump still seems exaggerated, given how low rates are compared with their long-term averages. 

"Issuers were not complaining about interest rates a few years ago," says Brendan Hanley, co-head of global investment grade capital markets at Bank of America Merrill Lynch (BAML). "An increase in interest rates from 1.5% to 2.45% is only a dramatic increase over a very narrow timeframe."   

The world is short growth and long cheap capital. Even though rates are rising, there is going to be cheap capital, by historic standards, for some time to come 
 
- Alasdair Warren, Deutsche Bank

The bond market is, however, treating it as a dramatic increase and is stampeding for the exit. Following 39 continuous weeks of outflows from the US equity market before the US election, there were $40 billion of inflows in the two weeks immediately following it, the lion’s share of which came out of bonds and ETFs. 

"Yields will rise further. This is the beginning of the unwinding of the global carry trade," says Robert McAdie, global head of strategy at BNP Paribas.

The last few weeks of 2016 were certainly rough for many fixed income and credit investors.

"When rates are falling, no one cares about fixed rates," says one. "But when they start rising, suddenly people who you thought were only interested in spreads start worrying about rates." 

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John Beck,
Franklin Templeton

John Beck, director in fixed income at Franklin Templeton in London, believes the reaction has been understandable: "We had a fall in interest rates before the election. If the 10-year UST is at 1.75%, there is not a lot of yield there to protect you against volatility. So it is understandable that you shoot first and ask questions later." 

Nevertheless, at the end of 2016 the bond markets were priced for an outlook that is by any measure unlikely in 2017.

"Look at Treasury forwards and the one-year 10-year is at 3.5%, which is a big reach," says Rajan. "That is likely unattainable. It is unlikely that you will be able to substantially increase inflation and potential growth enough for long-term interest rates to rise much from here." 

The election of Trump heralds a brave new world for the bond markets, but that does not mean the end of low rates – the long-term average rate of the UST 10 year is 4.59%.

"The world is short growth and long cheap capital," says Alasdair Warren, head of CIB EMEA at Deutsche Bank. "Even though rates are rising, there is going to be cheap capital, by historic standards, for some time to come."

Taper trepidation

Europe was shaken by the surprise reduction in ECB public-sector purchase programme (PSPP) monthly purchases announced by Mario Draghi in December. The decision to extend the duration of the QE programme but reduce monthly purchases was a taper of sorts – and totally unexpected by a market already shocked by Trump. 

One banker speaking to Euromoney before the announcement of the decision pointed out: "Central banks have made and broken the markets. What the ECB decides to do next year will be key. Any suggestion that they will taper will crush the markets." 

Others saw the move as more of a rightsizing of the programme.

"The fundamental reason for reducing the pace of monthly purchases is that €80 billion in asset purchases is too high, given the improving macroeconomic backdrop, especially as risks of deflation and de-anchoring expectations have become more of a tail event relative to the first quarter of 2016," says Philippe Gudin, chief economist for Europe at Barclays. 

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It is true that when the PSPP was increased at the beginning of 2016, this was presented by the ECB as a frontloading of QE.

European yields have risen on the back of the Trump victory and duration risk is now a big factor. As McAdie at BNP Paribas notes: "Yields in Europe are rising because the global term premium is rising." 

This has muted one of the more extraordinary features of the market during 2016 – negative-yielding corporate debt.

"The volume of negative-yielding corporate debt in Europe has reduced significantly from a high of €195 billion to €55 billion," says Jeff Tannenbaum, head of EMEA debt capital markets at BAML. "However, in a historical context, if you are at zero or close to zero rather than negative rates, you are still in a pretty good place as a borrower." 

This is good news for the ECB. The constant pressure of finding eligible bonds to buy in Europe could have also contributed to December’s taper-esque decision. 

Speaking before the announcement was made, Franck Dixmier, global head of fixed income at Allianz Global Investors warned: "It is difficult to anticipate whether the current Trump-inspired rise in yields will be sustainable. Should president-elect Trump’s economic policy disappoint, the consequent fall in US yields will have a direct downward pressure on eurozone yields."

Although yields outside the US have risen in line with it since November, 2017 will see the impact of divergence in central bank policy between the Fed and its European and Japanese peers. While the ECB is unlikely to expand QE to FIG, the recent extension of the programme shows the direction of travel.  

There is a view that borrowers have had sticker shock and felt they have missed their chance to fund cheaply. That is certainly not the case – even if you let rates run another 50bp they are still at historic lows 
 
- Marco Baldini, Barclays

A continued rise in European yields should not, however, be discounted. When US rates rise, European rates rise too, even though technically they should not. 

"I would expect the rate differential [between the US and Europe] to widen," says Marco Baldini, head of European bond syndicate at Barclays in London, "but the investor base is broad and global. The market is much more international than it was 10 years ago." 

The extent to which this divergence of monetary policy is reflected in yields between the various geographies will be a key theme of 2017.

"In Europe, the ECB has managed to thread the needle, engineering a benign taper and a steepener," says Rajan. "Limited growth and inflation prospects and a vigilant ECB will continue to put a lid on long-term rates there."

Repatriation

While it is difficult to determine how some parts of Trump’s agenda would impact the bond markets, his plans for US corporate tax repatriation are very clear. If the corporate income tax rate on the $2.5 trillion in profits that US firms hold overseas is cut from 35% to 15% that would mean huge cash repatriation that would optimistically be spent on M&A, or, maybe more realistically, go on share buybacks. 

The impact would be sharply felt in bonds.

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Brendan Hanley, BAML

"There is still a long way to go, but potential tax reform and the implications of the reforms could likely have a meaningful impact on how clients evaluate capital structure and specifically the structure and duration of the debt complex," says Hanley at BAML.

If it spurs M&A, that is good news for the large US banks that can provide sizeable and lucrative bridge facilities.

"In a low interest-rate environment, bridges are a super-attractive proposition for banks: they enable them to make interest income," says one banker. "Banks are therefore desperate for acquisition business as it is a prime source of revenue. Even European banks will step up for acquisition business. It is the best business." 

If, as Trump hopes, US corporates spend their tax windfall on M&A and expansion, this, together with fiscal stimulus, raises the spectre of inflation. How much of a concern this should be to the bond markets is a matter of dispute. 

"Trump’s programme will drive up the demand function and the labour market will overheat," predicts McAdie. Others believe that inflationary pressure is being over-anticipated. 

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"The risk of the US overheating is slim," says Beck at Franklin Templeton. "Inflation has picked up, but only since oil prices collapsed in 2014, and even full employment is not having much impact on wages. There are a lot of structural pressures driving wage costs down – such as companies like Uber. Global competition will keep long-term inflation pressure under control." 

Beck believes that both emerging market and corporate credit will be able to withstand US monetary tightening. 

"Headline inflation will rise with oil at $50 a barrel, but in the last 30 years oil has been anything from $8 a barrel to $148 a barrel, so it is difficult to predict with any level of certainty," he says.

The situation will have to be very carefully managed, however, and if the last few years in the capital markets have taught observers anything it is that rate rises are very hard to predict.

"If growth in consumer or commercial credit expands at a faster pace, it could suggest that inflation growth might accelerate sooner than expected," warns Jim Kochan, a fixed-income strategist at Wells Fargo Asset Management. "In that situation, the Fed might need to quicken the pace at which it raises rates." 

At its December meeting, the Fed indicated three rate rises are likely in 2017, up from two previously suggested.

Bankers confident – or maybe hopeful – that what rate rises there are in the US will not impact issuance.

"There is a view that borrowers have had sticker shock and felt they have missed their chance to fund cheaply," says Baldini. "That is certainly not the case – even if you let rates run another 50bp they are still at historic lows." 

BAML sees US investment-grade spreads tightening by 20bp in 2017 and supply falling by 17% – a big change. When inflation is on the agenda, investment-grade bonds will usually suffer.

"It’s noteworthy that the higher-quality, most interest-rate sensitive part of the bond market underperformed during the taper tantrum [of 2014]," explains Kochan. "By contrast, lower-quality high-yield bonds held up relatively well. 

"They did so again in November 2016. We typically don’t want to take on duration risk at a time when interest rates are likely to rise, but taking credit risk might make sense, especially if corporate earnings growth remains steady."

Corporate leverage

Investors seem confident in this course of action despite the rise in corporate leverage on both sides of the Atlantic.

"In the US, the increase in corporate leverage has been management-driven. A lot of single-A rated corporates decided to lever up to triple-B. There is still event risk, but there is a lot of discipline about not moving to high-yield. In Europe the increase in leverage has been different. It has been ebitda-driven not management-related," says Edward Farley, head of the European corporate bond team at PGIM. 

After a 16% increase in euro issuance by investment-grade non-financials in 2016, BAML predicts that 2017 will see corporate spreads widening in Europe as supply increases, the ECB’s CSPP continues and there is an uptick in M&A.

US high-yield is identified as a bright spot in 2017 partly because its exposure to the oil price has seen it so badly beaten up in 2016. The recent recovery in commodity prices has helped it, and many investors see it as a good bet in corporate credit in 2017.

"All of the shocks should have damaged the market more than they have," says Henrik Johnsson, co-head of global DCM at Deutsche Bank. "This is because of the huge amount of cash needing to be put to work. We have seen some rotation within fixed income into dollars and from high-yield to equities, but the dollar will eventually become uncompetitive and the market will rebalance." 

The boost in S&P has been driven by the Trumponomics reflation trade. Once yields rise there will be a correction back down again 
 
- Robert McAdie, BNP Paribas

European high-yield held up well in 2016, despite everything that was thrown at it.

"Liquidity has overwhelmed everything in high-yield," muses one London-based banker. "We had 48 hours of questions after Brexit, and Trump was the dip that wasn’t." As deals become ever more aggressive, however, the chance of a credit event in 2017 is ever-present.

For sovereigns, supranationals and agencies, 2017 will again be all about swap spreads. The narrowing of long-dated swap spreads led to a change in maturity from 2015 to 2016. Negative swap spreads kept 91% of issuance at the front-end (up to five years) in 2016, up from 78% in 2015.

 "Within the SSA market the real driver is what will happen to swap spreads, rates and the demand for duration," says Tannenbaum. "The big borrowers have had to learn to be nimble and react to volatility in swap spreads and rates on the back of events such as Trump’s recent election." 

One such big borrower is the European Stability Mechanism (ESM), which recently announced an increase to the long-term funding volume for the European Financial Stability Facility/ESM for 2017 to €57 billion. 

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ESM's head of funding Siegfried Ruhl

Siegfried Ruhl, head of funding at the issuer, is confident that market conditions are manageable.

"We are used to managing our issuance programme in a very uncertain environment – it is our business," he tells Euromoney. "What is key is having the flexibility to issue in different parts of the curve. In 2015 and 2016, we did dual tranches rather than one big benchmark trade, which enabled us to reach different investors. We have a wide investor base – low-end investors are quite active at some times and at other times fund managers become more active as spread levels become attractive. The dollar programme will increase our toolbox of funding options and will increase our investor base. We have to listen to the market." 

Expect volatility

If 2016 is anything to go by, there is one thing that the bond market should expect this year: volatility. 

McAdie argues that this is a good thing.

"Volatility is rising so there will be more dispersion across asset classes, sectors and markets. This is a healthy thing. There is little liquidity in the markets and correlation of returns to UST is at all-time highs," he said in mid-December. 

The trick will be spotting the trigger.

"In the past volatility in the market was often triggered by unknown events," says Baldini. "Recent macro events are well-flagged, but the market cannot predict how people react to the various drivers, and that causes uncertainty. In the first half of last year, everyone was focused on the oil price but for the rest of the year it dropped off the agenda." Oil hit a 16-month high in mid-December, however, after global production cuts were announced, so it could be firmly back on the agenda in 2017.

After years of monetary easing, the bond market enters 2017 with an uncharacteristically uncertain outlook.

"Investors adapt quickly to a change in the yield environment," says the ESM’s Ruhl. "It is, however, very difficult to predict how the yield environment will change as there is a lot of uncertainty. It is not clear what Trump will do, how fast he will implement what he does do and how the Fed will react. It is risky to take a position." 

For asset managers, however, that is their job. Calls for the end of the 30-year rally in bonds have been deafening since November 8, but simply selling up and rotating into equities is not the answer. 

"The boost in S&P has been driven by the Trumponomics reflation trade. Once yields rise there will be a correction back down again," warns McAdie. "There is the potential for a reversal of the bond to equity rotation once yields hit a certain level. For bond investors the pain in the risk-free portion of your attribution is the largest. A 50bp rise in US real yields will be an indicator for risk-off and will put money in the short end of the treasury curve." 

He suggests cutting duration and hedging rates: "The biggest pain will happen in duration and the second biggest pain will be in beta. At the moment, the market is long both. So investors should shift out of this and into short-dated or interest-hedged instruments."