The bond market plays a critical role in the functioning of the global economy as it ensures the efficient allocation of capital by matching borrowers to debt providers. Corporations in need of finance issue corporate bonds while governments with infrastructure and recurrent expenditure shortfalls also issue government securities to bridge the gaps.
Bond markets are impacted by both political and economic risks, and rating agencies attempt to play the referee by assigning credit ratings that drive or influence investor decisions. This article analyses current trends on the global bond markets with a focus on the Eurozone, USA and African emerging markets.
European fixed income markets are currently experiencing a thaw on the supply side because the political risks that were hovering over investor sentiments now a thing of the past.
The election of Emmanuel Macron as French President has brought forth some level of certainty about the future of the Eurozone, as the risk of a “Frexit” vote is now nearly impossible. This, however, increases the likelihood of an ECB taper of bond purchases, which has created an upward pressure on bonds issued by peripheral countries.
Quality bond supply from more stable, “core” countries such as Germany and the Netherlands is not helping the yield situation in these peripheral countries. In Italy, political risk and the strength of the banking system is also exacerbating the pressure on yields. The table below sourced from Bloomberg provides a trend of the ten-year government bond yield for Euro area countries.
Greek yields, however, still continue their stellar performance with investors expecting the economic recovery triggered by the third bailout to hold in the near term. The country has posted three quarters of growth post-bailout, which has depressed yields making it easier for the leftist Syriza to push and finance its reform and recovery agenda by getting back into the bond market at reasonable rates.
The 10-year Greek bond yield is still fractionally higher compared to its peripheral peers and core countries but the stability provided by continued economic recovery provides a much welcome impetus for investors to up its allocation in their portfolios.
Across the Atlantic, investor expectation is that the Fed will hike interest rates during the June meeting, primarily driven by a strong performance by the jobs market. April’s US employment report indicates that the economy added 211,000 jobs with the unemployment rate slowing down to 4.4%.
Economists are in agreement that the economy is close to full employment with the slowdown in the first quarter where a 0.7% growth was viewed as transitory. To avoid any overheating of the labour market, a rate hike would be prudent and would also keep inflation closer to the 2% target set by the Fed.
Government expenditure is also expected to increase with the Trump administration’s infrastructure agenda, which should further boost economic growth. Wages and home prices have been rising, meaning consumers have more spending power since they can borrow cheaply via equity releases of their homes.
The graph below plots the wages and salaries and average hourly earnings trends since 2014 which indicates an upward trajectory.
Home prices are also slowly rising though markedly lower than the 2007 peak, which pointed to the overvaluation that triggered the financial crisis in 2008.
How does this bode for US treasuries? Investor expectation is that the yield trend will converge with the Fed’s guidance of three hikes during the year, this has already started impacting the primary market with the 3-year note issued on Tuesday not performing well as investors expect the Fed to move upwards in June.
The 10-year note is, however, expected to perform better with traders coalescing at the 2.367% level compared to 2.332% noted in April. From a portfolio perspective, funds which are overweight in treasuries might need to revise their allocations as valuations come down with the rise in interest rates. However, the expectation is that allocation for newer treasury issues will rise, due to the increased yields that might have a downward pressure on the equity markets.
The outlook for emerging markets is not any rosier. The slide in the oil price, which has tanked to $46 per barrel essentially means that the near-term future cash-flow promises for oil-producing emerging markets, such as Nigeria, will heighten the risks attached to the bonds they issue and create an upward pressure on yields.
S&P’s downgrade of South African debt issues to junk status due to the political crisis triggered by the sacking of its finance minister also means that the country offers an attractive yield on its debt issues. This will make it difficult for the ANC government to deliver on its agenda as elections loom in 2019.
Kenya is currently on an electioneering period with the ruling Jubilee coalition up against the opposition NASA coalition. It is widely expected that investors will be watching the contest closely. Political risk premium should increase marginally with the shilling expected to come under pressure as foreign investors adopt a wait and see attitude, supply-side inflationary pressures might force the Central Bank to hike the benchmark rate. However, the argument for this move is watered down by the fact credit expansion to the private sector has declined since Kenya introduced rate caps in 2016.
The Global Outlook
On balance, sustained global economic growth should bode well for global equities in the medium term as corporate profits continue their upward trajectory. Confidence in the future of the Eurozone should drive consumption and fiscal expenditure growth, even as Brexit looms.
The US economy should also continue with its strong recovery even though uncertainty over protectionist measures proposed by the Trump administration could pose a risk. It is worth noting that China holds a significant portion of US treasury issues, meaning that any trade war might lead to a dumping of US treasuries by the Chinese government, which might, in turn, have an upward pressure on US treasury yields.