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by  BlueBay Fixed Income teamM.Dowding Aug 19, 2022

Passionate, insightful, contrarian at times and always a true thought-leader in his field, Mark Dowding shares fresh fixed income insights every Friday. His musings on the week cover macro developments, bond market trends and his latest positioning thoughts, with the odd joke thrown in for good measure. Subscribe to receive the latest weekly commentary.

Global government bond yields continued to rise during the past week, with markets focussing on the protracted overshoot in inflation being witnessed across Europe, in the wake of higher food and energy prices. Wholesale gas prices in the region are now at levels 10 times greater than were recorded last year and this continues to be a major source of concern, against a backdrop of supply disruption.

Despite governments seeking to protect consumers and businesses from the full impact of this energy shock through subsidies and grants, second round inflationary impacts are starting to show up more broadly in goods and service prices. Meanwhile, the recent drought in Europe is serving to exacerbate food inflation and shortages of fertiliser highlight the risk of further shortfall in food supply, in the period ahead.

As a result of these effects, it seems likely that eurozone inflation is only likely to peak at the start of 2023, whereas in the UK, the CPI is set to remain in double digits for months to come, possibly peaking around 15% in Q1 next year.

The squeeze on real incomes across Europe exacerbates recession risks. Yet, with ECB comments from Schnabel reflecting that higher interest rates are having little impact on bringing prices down at this point, it appears that central banks will continue to need to hike, even as growth continues to slump. This stagflationary backdrop is a challenging one and it is understandable that governments may want to cushion the blow by relaxing fiscal policy.

Yet, increased spending, at a time when government revenues are declining, threatens to balloon fiscal deficits across the region in the quarters ahead. Arguably, easier fiscal policy may mean that central banks have more room to raise rates further in due course and it is possible to perceive how yields may continue to rise throughout the course of the year ahead, unless better news on the inflation front can be forthcoming.

From this standpoint, we have been turning more bearish on the outlook for European duration of late. We also see a growing threat of this halting the recent risk rally, that has led to tighter spreads across sovereign and corporate credit in the region. Within Europe, we think that the stagflationary dilemma continues to look most stark in the case of the UK and here we continue to express a structurally bearish view on gilts, UK risk assets and the pound.

We also sense that any political debate seeking to weaken the Bank of England (BoE) mandate (so as to avert interest rates needing to rise too far in the short term) may only mean that interest rates need to rise more in the long term. Consequently, we believe that the UK curve should bear steepen, in contrast to recent price action that has led to a curve flattening.

Meanwhile, it is interesting to contrast the prevailing dynamic in Europe compared to what we see across the Atlantic. Here, it seems that policymakers are much more confident that inflation has peaked and is on a downward path. Moderating oil prices, a strong dollar and cooling in the housing market are all factors that can help to moderate prices in the months to come. In addition, in contrast to fiscal policy in Europe, which may serve to add to inflation, it has been striking how the US fiscal deficit has been shrinking in the past year as spending programmes wind up and as tax receipts surge, thanks to a robust economy. Having seen double digit deficits (as a % of GDP) in 2020 and 2021, the current quarter sees the US fiscal deficit running close to 3%. In this way fiscal and monetary policy has been well joined up in the US in the past couple of years, boosting the economy in the pandemic and more recently working to moderate excess demand.

From this standpoint, it would appear that US growth exceptionalism is unlikely to come to an end any time soon and fundamentally speaking the US economy looks in a much sounder position than is the case overseas.

In Asia, Chinese growth continues to flatline, thanks to the ongoing property market bust and mis-guided zero Covid policies. Authorities in Beijing have been adding to fiscal and monetary easing in the past week, but we are not convinced that steps taken to date will materially improve the outlook. Elsewhere in EM, the picture is more mixed reflecting different dynamics in the wake of economic composition and past policy measures.

Broadly speaking, those countries exporting food and energy continue to look to be in robust shape, whereas those who are importers remain very vulnerable. Orthodox policy actions have been helping inflation to peak in a number of countries and this may favour some local rates curves. However, there continues to be examples of those seeking to swim against the tide, with Turkey this week deciding that it makes sense to cut interest rates as a means of fighting hyper-inflation.

From a credit perspective, our macro views are leading us to favour the outlook for US corporates, relative to those based in the eurozone and we believe that adding hedges in Itraxx series, relative to CDX, offers scope to add to returns at this point.

Broadly speaking, we continue to look for opportunities to sell on strength and despite market technicals suggesting that a bearish consensus can act as a brake on spread widening in Europe, we observe that sector and issuer positioning are particularly important in order to protect the broader portfolio.

Elsewhere in currencies, we have been inclined to reduce currency risk as we do not see many clear cut opportunities at this point. We think the FX in Central Europe is structurally overvalued and remain short in Polish zloty and Czech koruna. Meanwhile, although we think the US exceptionalism can help underpin the dollar, we think that the greenback has now completed most of its move versus the euro.

Looking ahead

It remains hard to project a forward-looking view with too much certainty. Like the Fed and other central banks, we as portfolio managers need to remain in data-dependent mode. This means keeping an open mind to incoming information and not wanting to become too closely attached to individual trades. That said, running a structural negative bias on UK gilts remains appealing to us and more broadly speaking we are growing sceptical of how much yield curves can flatten / invert. For example, UK cash rates are now seen 125bp above 10-year gilt yields in 2023 H1 and this may appear unrealistic for a couple of reasons.

Firstly, we would reflect that pricing of long-dated yields seems to embed an expected return to the status quo that prevailed for much of the decade post the Global Financial Crisis. This may be unrealistic in our view and other decades may represent a more likely template than the more recent period dominated by the narrative of secular stagnation and falling rates of R-star. Secondly, we would question whether the BoE can, and will be able to deliver, as many rate hikes are discounted in the coming 6 months.

We also wonder whether it could become attractive for the BoE to accelerate Quantitative Tightening (QT), shrinking its balance sheet to tighten financial conditions, rather than raising rates and piling further misery on blighted consumers suffering from a massive cost of living shock. Trading QT for rate hikes could make sense when curves are inverted, as they currently are.

However, one wonders how long it might be before some bright spark tells Liz Truss that if the BoE are raising cash by selling bonds from its balance sheet, then perhaps the government could grab this cash to finance a few more tax cuts………. that said, you wouldn’t want to blame the government for clutching at any straws, given an outlook which seems almost as bleak as that being faced by Manchester United fans, only two games into the new season.

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