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Fixed Income Letter - Macroeconomics matters!

EDITORIAL

Post French Presidential elections, which represented the main political risk for the Euro Zone this year, markets should refocus on fundamentals.

Better sentiment, synchronized global growth impetus, slow reflation, and potentially some fiscal stimulus in the US (with a low bar to surprise now), should push the market to question the level of accommodation of central banks and the rich valuations of fixed income markets.

For these reasons, we have decided to turn our visibility indicator to green, as we are ready to take on more risks in our global fixed income portfolios. As a result, we increased our short duration position especially on the US curve as rate hike expectations for 2017 and 2018 went down too far (with only 2 rate hikes expected after June in the next 2 years). 

 

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Growth acceleration in Q2 and discussions around the Fed balance sheet policy should support this view, as well as any news on the fiscal front as the unwinding of Trump’s trades has left the market more sensible to a positive announcement. In the euro zone, we kept our short position on core duration as attention could turn to the ECB and the way it could start to normalize its monetary policy in a context where macro data remains well oriented. We went cautiously long again on periphery after the first round of French Presidential elections as political risk was fading, euro zone growth is supportive and steep peripheral curves offer attractive carry and roll down. However, with expectations of ECB tapering increasing, debt sustainability will remain a concern and political risk could resurface later (Italian elections expected in Q1 2018, potentially sooner). We also maintained our short UK duration, as valuations look very rich and inflows into this market could be challenged by risk aversion linked to Brexit negotiations. We also remain long inflation breakevens in the US and in EUR, as the recent fall in commodity prices and doubts on Trump’s policies have pushed them too far down, whereas the outlook for core inflation remains positive.

On the credit side, the market should also refocus on fundamentals, which remain good. We kept our long position despite tighter valuations. We are especially positive on European financials, with French and Italian banks and assurances catching up after the French elections. However, on the corporate sector, we prefer the US market.

Fixed Income Letter 201705_img1

 

 

Laurent Crosnier,

CIO Amundi London

CONVICTIONS

Rose-coloured glasses

Killjoys will probably say that the clouds on the horizon won’t truly dissipate until French legislative elections, UK elections, and German (and even Italian) elections are over. But the real danger lies is waiting too long for all risks to vanish before gaining exposure in the funds, by which time the market will have adjusted to economic data. It happens that, on the economic front, the euro zone (and Europe in general) is showing clearly positive momentum, with more growth and growth that, moreover, is more evenly distributed throughout the euro zone (with less fragmentation), resolutely positive inflation (far from the deflationary fears still being felt just a few months ago), receding unemployment, and both consumer and business indicators up.

So duration will not be your friend in the coming months, even though a steep increase in interest rates is unlikely. For, even if the 10-year Bund were to rub up against 1% we would still be in an environment of extremely low rates. However, the lack of carry in core sovereigns is not enough to absorb a rate increase, even one of just a few tens of basis points. Assets trading at premiums that boast solid fundamentals should perform well. Non-financials and financials (especially the subordinated tranches of their issues), including high yield, are still getting support from abundant liquidity, which is keeping default rates very low. So it makes sense to overweight these asset classes in the portfolios. Among sovereign issuers, it is worth overweighting those countries with positive economic momentum (Spain and Portugal, as well as some non-euro zone sovereigns that have just issued in euros, such as Israel and Poland, for example). Lastly, the inflation play, which has fared poorly so far this year, should regain strength in the coming months. These positions have been set up in our Euro Aggregate portfolios. Bets on inflation and assets trading at premiums, for example, have been implemented in the Euro Inflation and Corporate Hybrids Bonds strategies.

 

Marie-Anne Allier,

Head, Euro Fixed Income Paris

 

Risk is expensive: take advantage

All financial asset prices have a volatility component. Market pricing of volatility is at or near post-GFC lows, as shown in the accompanying chart. In fixed income, lower volatility means a lower yield for longer bonds (lower term premium), tighter spreads for corporate bonds (lower default risk) and tighter spreads for government MBS (lower prepayment risk).

Fixed Income Letter 201705_img2

Why is the pricing of volatility so low, and what are the prospects? Markets were braced for a possibly unpredictable new U.S. president and large changes in U.S. fiscal policy, but both factors have failed to produce market-moving surprises. In European politics, possibly disruptive elections have recently favored the status quo. Economic growth has been steady and not too strong around the world. Central banks on balance continue to follow easy monetary policy as they seek higher inflation. Financial leverage does not appear to be a concern. Finally, higher prices and lower volatility reinforce one another as lower risk pricing allows many market participants to increase their positions.

Momentum is great, but value is eroding. What’s the playbook? We are value investors. We think it’s a great time to upgrade credit, upgrade liquidity, reduce spread duration and favor quality.

It is hard to say how long volatility will stay low and the punch bowl full. Last decade, we had a low-volatility regime for several years, although this occurred in the presence of lower capital requirements and greater leverage capacity—which prolonged the regime and then made the correction more severe. The U.S. Federal Reserve has well noted the combination of near-capacity labor markets and easy financial conditions and is pressing on with the normalization of rates, and soon its balance sheet. The FOMC will continue moving toward a neutral stance unless growth abates or financial markets excessively “tighten” in terms of higher interest rates, lower equities, wider corporate spreads or a stronger dollar. Further areas of long-term (or sooner) concern include high global debt levels, ascending populist political movements and slow or non-existent reform. Any progress toward higher inflation in the U.S. or abroad could be destabilizing.

As of press time, U.S. real interest rates are reaching relatively attractive levels. We continue to see good value in U.S. housing credit. And we’re ready to add U.S. government mortgages if the interest rate markets can loosen up yield spreads with some short-term volatility.

 

Dan Dektar,

CIO Amundi Smith Breeden

 

Strategy in Tokyo

Soon after the introduction of YCC (“yield curve control”) by BOJ last September, participants in the JGB market tried to resist such an abnormal policy by challenging the floor at 0% or the ceiling at 0.1% for 10 year JGB yield. But what they confirmed is 10year JGB was contained within the range set by BOJ whatever happened to global economy. As a result, 20 year and 30 year yield also moved within a quite narrow range of around 15bps. Shorter end of the curve was also affected by anchored 10 year yield to allow 5 year yield to move 7bps and 2 year 6 bps.

Though the degree of movement is very small, JGB curve still provides us with opportunities to take positions based on relative value analysis.

  • Maintained relative value positioning based on yield cushion analysis: long 2, 7, 10, 20 year at the cost of deep short position in 5 and 30 year.
  • Added 10-20-30year butterfly (long 20 year and short in 10& 30 year)
  • Added BEI position instead of reducing some of flattening position to take profit after seeing flattening in 2-5 year curve.
Fixed Income Letter 201705_img3

 

Credit market was very quiet in April as a new fiscal year just started and many financial institutions were busy to establish new investment strategy for the new year. So far, no news is good news for credit market though geopolitical risk in North Korea may negatively affect Japanese credit market.

  • Overweight in shorter end of Japanese credit sector with maintaining weighted duration of credit portfolio neutral.

 

Shinichiro Arie,

CIO Fixed Income Amundi Japan

 

BRARD Eric , Global Head of Fixed Income at Amundi
CROSNIER Laurent , CEO & CIO at Amundi London
ALLIER Marie-Anne , Head of Euro Aggregate at Amundi
ARIE CFA Shinichiro , Head of Japanese FI at Amundi Japan
GUIVARCH Patrick , Head of Insurance Solutions at Amundi
CHOW Philip , Fixed Income CIO, Amundi Singapore
DEKTAR Daniel C. , Chief Investment Officer, Amundi Smith Breeden
ADLER Dan , Amundi Smith Breeden

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Fixed Income Letter - Macroeconomics matters!
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