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Fixed Income Letter - World markets or how to expect the unexpected

EDITORIAL

A combination of potential factors including the political uncertainty in Europe, Central Bank meetings in March and unpredictable tweets from Trump will result in an intense upcoming few weeks. Currently, there appears no sign of any source of stress in the markets: risky assets are performing well and volatility remains at a benign level. Markets were priced for the best outcome, with little impact resulting from the rise in probability of a March hike from the Fed. This is all the more surprising, given the level of uncertainty ahead of us, we view this indifference to risk as being akin to driving your car at full speed through fog.

Given these circumstances, it is optimal to implement portfolio strategies that will benefit from any kind of derailment of anticipated or unanticipated events. The most obvious would be to buy cheap volatility in some market segments which might react strongly should the unexpected happen; forex volatility being one of those strategies.

Coming back to the US, Janet Yellen’s latest speech alongside other Fed members indicated that a March rate hike is in play with a probability above 80% and the DXY index (which measures the strength if the US dollar vs. other developed markets currencies) moving upwards towards 102, a level not seen since the end of last year. There is however, a positive surprise coming from emerging markets, where despite a very bearish forecast on emerging markets currencies after the Trump election, that was made worse by stronger dollar and fears of a trade war, the emerging markets debt complex is actually doing very well. Both local and hard currency debt are out-performing developed bond markets, proving that the economy matters more than politics. After the US election, the main casualty was the MXN and the Mbonos (local currency denominated Mexican government bonds) market as the currency lost nearly 20% from peak levels, putting some pressure on the Central bank to tighten monetary policy. More importantly in this region, has been the strong relative performance of the BRL versus the MXN.(source: Amundi, March 10th)

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Hedging politic headline risk against the macro economic backdrop through relative value positions is a way to deliver consistent excess return without taking excessive market beta risk. The MXN is now a high carry currency and offers more value after having priced downside risks for Trump. The demand for hedging on the MXN was distorting the volatility surface, allowing investors to enter the opposite trade (long MXN) at a zero cost as well as adding convexity to the position.

Cleary, the coming weeks will be about navigating in this political landscape, especially in Europe, where the political calendar is loaded. Looking at relative value trades or entering directional positions through options will deliver value especially as markets are moving from a lower form of efficiency towards a more behavioural based pattern. It is now that portfolio positions should be anchored to strong macro analysis which acts as our guiding lighthouse through this political fog.

 

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Laurent Crosnier,

CIO Amundi London

 

CONVICTIONS

Energy transition and the emergence of fixed income solutions

The green Bond market is only at its early stages of development but is experiencing steady growth amidst a “friendlier” market and regulatory environment – e.g. Article 173 in France – along with more investors’ consciousness over non-financial risks. With more than $75bn of new green bonds issued in 2016, the green segment is on the same steady growth, in 2017, with the latest noticeable new French inaugural, largest (Eur 7bn) and longest maturity (22 yrs) green bond issue. Now the Green Bond market exceeds $ 170Bn, according to data compiled by the Climate Bonds Initiative (CBI).

We expect this uptrend to be validated in the next few years as more governments participate in developing their Green debt and as Emerging Countries engage measures to meet their green financing needs. In addition, demand is strong as investors in developed countries convey a great interest to responsible investment. Thus, a larger, deeper and more diversified green bond universe will be even more visible and tradable in the years to come.

The steady development of the green bond market is indeed a good news for Impact Investing. The Green Bonds Principles already provide guidance to gauge the environmental impact of Green Bond investments. Over the last few quarters, more issuers have significantly improved their reporting by providing measures on environmental benefits such as energy efficiency, renewable energy generation or the avoidance of GHG emissions. In doing so, a Green Bond becomes an Impact Green Bond. By aggregating these indicators into an investment strategy, investors are empowered to develop “Impact” denominated strategies and optimize financial and environmental benefits. Furthermore, Green Bonds broaden the universe of “Impact investing”, primarily focused on social indicators, into environmental themes through more liquid and more diversified fixed income assets.

At Amundi, our Impact Green Bonds strategies rely on a unique Fixed-Income platform combining global market coverage and deep financial and extra-financial capabilities. Moreover, our Impact Green Bonds strategy offers a tailored “Impact reporting” aiming at avoiding between 1000 and 1500tons of CO2e per M€ per year. This “Impact tag” is provided by type of project and by geography.

 

Alban De Faÿ,

Head of Green & SRI Processes

 

Asia fixed income: China takes steps towards bond index inclusion

In late February, China’s State Administration of Foreign Exchange (SAFE) has notified that foreign institutional investors in the interbank bond market will be allowed to use FX derivatives on onshore CNY over the counter to manage their FX exposures for hedging purposes. This confirms earlier guidance by senior PBOC officials and markets were expecting this. However, this move came earlier than expected and is an important hurdle for China to get included into the major bond indices. This is a clear signal by Chinese policy makers targeting bond index inclusion.

Citi indices followed up with an announcement in early March that it will include China onshore bonds to its emerging markets and Asian bond indices. China will join the emerging market and Asian government bond indices in February 2018 and its weights will be capped at 10% and 20% respectively. We believe inclusion into other EM bond indices should follow suit by in the coming months but the estimated inflows of about $20bn is unlikely to materially affect the balance of demand and supply of Chinese bonds as it is small relative to the size of the onshore Chinese bond market. This could potentially hurt other markets displaced by China’s inclusion. For example, the weights of Korea, Indonesia and Thailand within the Asian government bond index will fall and similarly for Mexico, Brazil and Poland in the emerging market government bond index.

There is no change to the World Government Bond Index (WGBI). Citi instead created two new indices (a WGBI-DM that excludes emerging markets and a WGBI-Extended to include emerging markets including China) so as not to affect its current global investor base using the WGBI index.

The inclusion of Chinese bonds into larger global indices are more likely to come later. The newly created global indices such as the WGBI-Extended and Bloomberg’s Global Aggregate + China indices to accommodate the inclusion have about 5% market weight in China. This could potentially have a larger impact on Chinese bond markets given the significantly larger assets under management benchmarked to these indices.

By end of 2016, overseas investors account of about $130bn of China onshore interbank bond markets but this still only accounts for only 0.1% of the total China bond outstanding. It is clear that China policy intent is to cross the hurdles to get China included into the major bond indices, particularly the global indices to encourage inflows. The restrictions on capital outflows have helped so far as we saw the renminbi trading quite stable this year. The renminbi internationalization process were halted due to a crackdown on capital outflows and so the move towards bond inclusion will be a step back in the direction of internationalization.

 

Philip Chow,

CIO Amundi Singapour

 

Decrypting the rule maker…

Over the past few months, the BoJ and other market participants have been playing a “whack-a-mole” game. The BoJ, as the owner of the game, has introduced several new controlling measures to contain the JGB curve, whilst market participants attempt to break the anticipated range. In February, the BoJ revised its monthly announcement of its JGB purchase operation by disclosing the date of operation and the expected amounts to be purchased. In doing so, the BoJ confused market participants by indicating a potential decrease in the purchase amount of short mid-term JGBs. This kind of confusion may increase the volatility of the JGB market, which would be a reversal of the current trend.

It is becoming less rewarding to take flattening positions based on the expectation that the BoJ’s Yield Curve Control (YCC) policy will be sustained. Capturing the distortion of the shape of the yield curve through a barbell strategy seems to work well.

  • Relative value positioning based on yield cushion analysis: long 2, 7, 20 years at the cost of deep short positions in 5 and 30 years.
  • Inflation Breakeven (BEI) position will work well supported by an increase in inflation expectations.

Japanese corporate bond markets may still generate strong returns thanks to the corporate bond purchase program by the BoJ, making it difficult to go underweight in credit sector.

  • Neutral/slight overweight in Japanese credit sector.

 

Arie Shinichiro,

CIO Fixed Income Amundi Japan

 

USA - Uncertainties among politics and Fed action

Markets are well known to anticipate events, but recently U.S. markets continue to run higher based on expectations of economy-friendly policies of the new president and Congress even though day by day these policies seem to recede into the future and diminish in likely impact. Health care reform has moved to the front of the queue and is predictably proving to be complex and divisive. With regard to economic policy there is no consensus, even among the majority party, as to major changes in tax and spending priorities. The new administration has started to put its people in place, but is inexperienced in the practice of governing. Substantial economic policy ideas have been lacking or vague. The opposition has been aroused by statements and proposals largely unrelated to economic policy.

In short, the scope for mark-to-market disappointment is growing daily. Market prices reflect increasing optimism although rational expectations for policy change must have diminished. Is the market applauding the greater likelihood of continuing “gridlock” in Washington? Is it merely reflecting improved economic data and rising economic sentiment?

In fixed income, corporate and high yield spreads are on the tight side, at roughly the 35th historical percentile in investment grade and in the bottom quartile in high yield. To repeat our mantra, uncertainty is high and spreads are low. Liquidity may be fine in upwardly mobile markets, but we are sure that prices will fall faster than fundamentals in downward markets as liquidity scampers away. One should now be underweight credit in general, with the good news that the odds of cheaper valuations ahead are rising.

The Federal Reserve has taken note of the improvement in financial conditions (stocks, the dollar, bond spreads and rates) and appears eager to raise the short-term rate as quickly as possible, as of now likely beginning on March 15. The Fed’s focus on financial conditions is another headwind for risk assets—in fact, that is the Fed’s mission.

TIPS remain likely to benefit from firm headline inflation but may not have much relative upside for a while. The best scenario for TIPS would be aggressive U.S. fiscal expansion which is accommodated by Federal Reserve policy. As explained above, that scenario appears less likely now than two months ago. Nonetheless, any movement to significantly higher rates would probably see TIPS outperform, which is why we value them as a core portfolio asset.

 

Dan Dektar,

CIO Amundi Smith Breeden

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

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Fixed Income Letter - World markets or how to expect the unexpected
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