The four themes shaping bond markets

Risky assets, such as equities and credit spreads, have performed better than the recent run of poor economic data would normally have suggested.

They appear to be finding support from defensive investor-positioning and the expectation that central bankers are likely to expand their balance sheets again before too long.

Furthermore, data surprises have stabilised of late and there are good reasons to assume that we are due a run of better data later this year, helped by falling inflation and policy easing. 

That said, it is still too soon to sound the all-clear and a range of issues could cause risk markets to turn more bearish.

In particular, Spain and possibly Italy are at risk of losing market access. The European Central Bank (ECB) buying up bonds and the limited European bailout funds may only provide a temporary stopgap if this were to happen, despite the ECB’s latest guidance suggesting more aggressive support. 

The apparent progress made at the June summit now appears to have papered over large remaining differences between what is acceptable to the eurozone’s creditor countries and the rest.

A Greek exit remains a real risk, given there is little chance that the country will be able to meet the commitments on which its funding agreement is based.

Away from Europe, we are concerned that the Chinese economy is proving disappointingly slow to respond to looser policy, and US businesses are potentially postponing investment and employment decisions ahead of a possible fiscal cliff.

Consequently, we continue to be fairly defensively positioned.

In light of this economic framework, we outline four current themes for the third-quarter, looking across the spectrum of the fixed income asset class: 


Government bonds priced for a more bearish backdrop than equities

Short-dated bonds in a number of core markets are now trading with negative yields. Core bonds were universally bid up until ECB president Mario Draghi’s pre-Olympics speech.

Thereafter, long-end yields mostly gave back approximately half of their gains on the month, before the likelihood of a substantial policy intervention from the ECB at the August meeting was questioned and defensive positioning returned.

The primary risks to core bond yields – aside from excessive long-term over-valuation – continue to rest with unconventional policy interventions from the Federal Reserve and especially the ECB.

While the latest ECB guidance has reduced tail-risk within markets, the difficulties facing Europe have not been conclusively dealt with. 


Short positions in the euro and commodity currencies are good hedges

July was very much a split month in the performance of the majors against the dollar. European currencies – with the exception of an unusually strong Swedish krona – were weaker, while the higher-Beta G10 FX rates posted similarly sized moves in the opposite direction.

The same broad pattern was evident among emerging market currencies. Both cyclical and secular forces remain more tilted in the US dollar’s favour than the converse, with signs of improved competitiveness and stronger housing data reinforcing evidence of a shortage of dollars in funding markets.

We believe that it has scope to make further gains and although renewed quantitative easing may limit the dollar’s upside, this has to be viewed against easing elsewhere, especially in the euro area.

Risks have arisen surrounding the near-term outlook for the euro, as the potential for more meaningful policy interventions lingers. Similarly, the same prognosis applies to the commodity bloc, although even less ambiguously. 


Emerging markets an attractive prospect

Hopelessly low or negative yields in core markets have encouraged investors to reach for yield in emerging markets and flow data continues to illustrate additional capital moving into this asset class.

Local emerging market debt saw further gains during July, although these were more subdued than those seen in the previous month.

The performance provided by hard currency emerging market debt reached unprecedented levels, with yields here breaking below the 5 per cent mark during July on aggregate.

Yields are at record lows in absolute terms, but versus developed markets the spread remains around the long-term average. 


Corporate credit poised for further gains

On a macroeconomic level, the most recent economic data has disappointed. We have also seen the first signs of revenue growth slowing and we expect this trend to continue.

However, profit margins remain at high levels, reflecting the steps companies have undertaken in the past few years to improve profitability. Default rates remain low, with default rates in Europe below those in the US.

Rates are forecast to increase from these low levels, but only very modestly over the remainder of the year. Investment-grade spreads once again posted a solid month of compression during July, with high-yield spreads mostly going sideways after a good recovery in the previous month. 

Consequently, valuations have not improved here, but are not as stretched as in other higher-yielding markets.

Many risk assets have become less sensitive to high-frequency fundamental developments. Rather, perversely flat sovereign yield curves, investor positioning and expectations surrounding central bank actions have maintained demand at a higher level than was possibly deserved.

This broadly applies to corporate credit, suggesting that further gains appear probable in the short-term. 

Given strong company fundamentals and low real interest rates globally, credit remains an attractive asset class over the medium-term, although returns in the near-term could be volatile. As such, we remain defensively positioned and a selective buyer of risk. 

John Stopford is co-head of fixed income at Investec. The views expressed here are his own.