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This quarter, bond investors are left asking two important questions – 1) Can the rate of vaccinations outpace the increase in new infections and the emergence of new variants, subduing the virus and allowing restrictions on economies to be eased? and 2) How much higher will markets push bond yields in anticipation of a strong, post-COVID recovery before central banks step in?
Currently, the US is leading the way with both an aggressive inoculation push and an equally forceful effort to drive growth higher, so vigorous that there are concerns the economy might overheat in 2022 and 2023 and that inflation might overshoot the Federal Reserve’s target sustainably.
We expect the Fed to tolerate increases in longer-dated yields that do not tighten financial conditions. A rise in 5y5y real yields to sustainably above 0.75%, however, will start to hurt other asset markets, i.e., equities, and might require action. Expectations of an inflation overshoot will cause investors to continue to buy inflation protection and push 10-year breakeven inflation wider.
In the eurozone, we expect improving inflation and expectations of a robust economic rebound to point to Bund yields trading between -0.4% and -0.2% this quarter, with a risk for a breach of 0%.
We do not see much scope for higher breakeven inflation rates. These rates have already rallied by more than those in the US. Also, core inflation is seen easing to closer to 0% YoY over the summer.
We are overweight in Italian government debt versus that of core eurozone countries, although we see limited room for Italian bonds to continue to outperform. For spreads over Bunds to narrow further, markets will need a game-changing catalyst.
Given a substantial improvement in both the public health situation and the growth outlook, and the prospects of slower asset purchases and hawkish central bank rhetoric, UK Gilts look vulnerable to a further sell-off. Increased pension fund liability hedging should support longer-dated real yields.
Continued government support for business should underpin corporate bonds, helping to contain bankruptcies and defaults. However, spreads are already back at pre-pandemic levels. Regionally, we prefer the US given the buoyant economic and earnings recovery and eurozone ‘peripheral’ debt.
In emerging markets, most economies are expected to return to pre-pandemic levels of GDP by the end of 2021. Debt levels have risen, but debt sustainability has not become an issue. Given the prospect of higher US interest rates, we are neutral on duration.
Within hard currency EM debt, we favour market segments where spreads have not yet returned to pre-pandemic levels. We find high-yield in particular appealing. We favour Asia corporate bonds thanks to the advanced economic recoveries and attractive excess spreads over US high-yield.
We are positive on China. Technicals and valuations look positive. China debt offers investors diversification opportunities and a higher yield, while the risk of default appears to be contained.
We expect the US dollar to weaken versus emerging market currencies, whose valuations look attractive on a real, trade-weighted exchange rate basis. We expect EM currencies to benefit from further inflows, stable current account balances and resilient foreign exchange reserves.
Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients.
The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.
Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).
Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.
