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Global bond markets : « too far, too fast ? »

Global bond markets, especially emerging markets, took it on the chin over the past five trading days as investors reacted to the U.S. election results and soaring expectations of a Federal Reserve rate hike in December.

In the U.S., the S&P 500 gained +1.96% while the Bloomberg Barclays Aggregate Bond Index gave back -1.76% between the close on 11/8 and the close on 11/15. A similar pattern was seen in Europe and Japan. The MSCI Europe Index of stocks rose +1.34%, while the Bloomberg Barclays EU Aggregate Treasury Index and the Bloomberg Barclays EU Aggregate Corporate Index fell back by -1.3% and -0.7% respectively. Japan’s Nikkei ended up +2.9% while the yield on 10-year JGBs jumped 70 basis points (bps) from -0.61% on 11/8 to +0.09% on 11/15. In emerging markets, both stocks and bonds were in full retreat. The MSCI Emerging Markets Index fell -6.7% and Bloomberg Barclays EM USD Aggregate Index retreated -3.13%. The broad sell-off was largely attributed to rising uncertainty about the future path of U.S. trade policy. However, by Tuesday there were growing signs that selling in EM markets might be abating as both the MSCI Emerging Markets Index and Bloomberg Barclays EM USD Aggregate Index posted gains for the first time since November 8th.

ON THE RISE

U.S. yield curve – too far too fast? Both short-term and long-term U.S. Treasury rates have increased since the U.S. election. However, longer-term rates increased more—resulting in a steeper yield curve. The spread (difference) between 30yr and 2yr Treasury yields was 196 bps on 11/15, 23 bps wider than on 11/8. This rather sharp steepening in the curve was attributed to hopes for stronger economic growth fueled by infrastructure spending, reduced regulation and tax cuts from the new Administration—something consistent with rising inflation expectations. However, this is not an entirely new trend: The 30yr/2yr spread had already risen 25bps from its low this year on July 8th—suggesting that the market was already pricing in an acceleration in growth and inflation prior to the election. How the curve behaves in the weeks ahead will likely depend on changes in the real economy, but it’s important to remember that the path from campaign pledge to implementation will undoubtedly face hurdles. What remains to be seen is how many rate hikes might follow if growth actually does accelerate into 2017.

A notable shift in the curve

UK pound – bucking the trend The UK pound was the only G10 currency to gain against the U.S. dollar in the past five days (+0.63%) – and the only one showing gains against it over the past month (+2.39%). Yet the currency is still down over 16% from its level just prior to the Brexit vote, bearing the brunt of uncertainties about the timing, terms and impact of the UK’s exit from the EU. Despite that, equity and bond investors appear unfazed: the FTSE 100 index of UK stocks was up over 7% between 6/23/16 and 11/15/16 and 10-year GILT yields have fully recovered from sharp declines in the wake of the vote. The market action in equity and bond markets seems more consistent with the surprisingly resilient economic data that has been reported since Brexit than does the weakness in the currency. Of course growth could still falter significantly, but if it does not, it raises the possibility that pound sterling may be undervalued and due for a snapback.

ON THE SLIDE

EM selloff – enough already? All 24 emerging market currencies tracked in Bloomberg’s World Currency Ranker were down versus the US$ over the past five trading days, including a -6.1% drop in the Brazilian real, a -5.2% drop in the South African rand and a -2.1% drop in the Mexican peso. The currency weakness was accompanied by sharp pullbacks in EM stock and bond prices as well. The broad sell-off was largely attributed to rising uncertainty about the future path of U.S. trade policy in the wake of Donald Trump’s election. However, by Tuesday there were signs of stability, with more than half of the EM currencies gaining versus the US$ including big gains by the Russian ruble (+2.9%), the Mexican peso (+2.1%) and the South African rand (+1.8%)—EM stocks and bonds ended the day generally higher as well—all serving as a reminder that knee-jerk market reactions are often quickly reversed—creating opportunities that active managers can seek to exploit.

Has the sell-off in EM currencies created opportunity?

High yield defaults – declining forecast While the Moody’s global speculative-grade default rate was 4.7% at the end of October—above the 4.2% average (since 1983)—the ratings agency expects it to fall to 4.3% by the end of the year and decline further to 3.3% by the end of October 2017. More than half of the defaults reported in the first 10 months of 2016 were in commodity-related sectors. With improved conditions for commodities sectors (the CRB All Commodities Spot Index is up +9.85% this year through 11/15/16), the prospect of these companies meeting their debt obligations is also arguably brighter.

Legg Mason , November 2016

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