A brave new world

IFR Awards 2018
10 min read

With the US Federal Reserve shrinking its balance sheet and the ECB emerging from quantitative easing, the bond market is likely to present opportunities in corporate debt.


In September 2017, the then US Federal Reserve chair Janet Yellen announced the great unwinding of the central bank’s 10-year stimulus programme. It would be as uneventful as “watching paint dry”, she said, with fingers crossed.

European Central Bank president Mario Draghi followed suit in June this year, saying that he intended to reduce the monthly pace of asset purchases to €15bn until the end of December and then end purchases altogether.

So what’s going to happen now? What does the new world of monetary policy, one in which two of the world’s biggest central banks aren’t pouring money into the markets, mean for the bond markets?

There is no consensus on what is going to happen. There is not even consensus on what has happened, though most agree that 2018 has been a horrible year.

Matt King, global head of credit products strategy at Citigroup, explained the two main schools of thought. Central banks, he said, reckon that this year has been one of bad luck. “Markets should be following the economy and the economy is in good shape,” he said, adding that central banks shrug off the flatness of the yield curve.

The other school of thought is that there is too much money chasing too few assets and with the end of quantitative easing, vulnerabilities are becoming visible again. “If that is the case, the markets are leading the economy,” King said.


The landscape becomes a little clearer if the US and Europe are considered differently. The Fed is the furthest along. Not only has it stopped purchases of bonds, it is in the middle of the process of normalisation and of shrinking its balance sheet.

Guy Miller, chief market strategist and head of macroeconomics at Zurich Insurance, believes that this both makes sense and is a reflection of a strong US economy.

“It is perfectly reasonable to normalise monetary policy. The fundamentals warrant higher rates,” he said. That noted, as policy tightening takes effect, and some of the fiscal measures wear off, the economy is likely to slow in the year ahead.

The wild card, or perhaps more appropriately the loose cannon, is US president Donald Trump. The wave of global QE coupled with his tax cuts have allowed US markets to shrug off his idiosyncratically antagonistic style.

Indeed, there is a persuasive argument that US markets are likely to calm down next year now that Trump’s economic agenda has been constrained by losing the House of Representatives to the Democrats in the November mid-term elections.

“Had Trump retained [the House], then there could have been an increase in the deficit and higher rates. He would have followed through with additional stimulus measures,” said Gordon Brown, co-head of global portfolios at Western Asset Management.


While Trump’s main focus has always been the equity markets (“Trump’s scorecard is the stock market,” is how one banker put it), global collateral damage has been felt in emerging debt markets, where costs of borrowing have rocketed in US dollar terms. The US might “only” make up 20% of global GDP, but most economies are reliant on some form or other on the US dollar. Its strength has caused problems.

The impact has been most keenly felt in Turkey, Argentina and Indonesia.

“EM markets are currently priced for extreme pessimism,” said Francis Scotland, director of global macro research at Brandywine Global.

The tricky part is to work out how much of the bad news is now factored into bond prices. Some markets such as Argentina and Turkey clearly overshot, and as one portfolio manager makes clear: “Not all emerging markets are created equally”.

All eyes are on China, not only because of its own slowdown in growth, but also because of the trade tensions that have dominated the news this year.

And this is where it loops back to the US. Scotland is pragmatic about the threats and calls US pressure on China “mutually assured destruction”.

Given that 40% of the S&P 500 comes from manufacturing, protectionism is likely to blow back into the US economy. Analysts throw a retreat in commodity prices and the rise in oil prices into the mix, and most now see not a recession, but a meaningful slowdown in the US next year: growth down to 2.5%–2.75%.

This scenario – and it certainly appears the most plausible – will see a more incremental rate at which the Fed hikes interest rates.

“Since December 2015, we’ve seen seven interest rate increases of 25bp, which have brought the target range for the federal funds rate to between 1.75% and 2.00%. This would indicate that we have come a long way already in terms of rate hikes. We are more constructive on the bond market given how far we have come over the past three years and see an increased possibility of positive returns,” wrote Chris Pariseault, Fidelity’s head of fixed income and global asset allocation, in a note to clients.


But while the US is looking clearly into the post-QE world, Europe is just emerging from it and in many ways still has a safety net firmly attached.

Christoph Rieger, head of rates and credit research at Commerzbank, describes the ECB’s retreat from QE as a “smooth exit”, if indeed you call it an exit at all.

“The ECB does not want to call it the end of QE, rather the end of the net-asset purchase programme,” he said.

Not only does the ECB have flexibility and intent to purchase debt in a market-neutral manner, it has also made it very clear that interest rates are going nowhere any time soon.

In a note in November, Deutsche Bank captured general market sentiment when it said that the ECB is unlikely to hike the deposit facility rate until September next year – and then by only 15bp.

This means that bond yields are likely to rise in Europe, but only very slowly, and the negative yields in shorter term German Bunds are here to stay for the foreseeable future.

Certainly, the additional concern of Italy is going to keep a lid on any sudden moves.

“Italy has created uncertainty and Italy’s problems are Europe’s problems,” said one analyst in Frankfurt, while another cautioned against underestimating the problem.

With all of the problems that Italy’s budget scrap with the European Commission brings to the table, it is no wonder then that few are expecting any dramatic movements upwards in debt prices.

“The ECB is managing the exit as clearly as it can. Yes, it has signalled the end of QE, but it has also anchored the low rates for the future. Do we expect a market meltdown? I don’t think so,” said Eric Cherpion, global head of DCM bond syndicate for Societe Generale.

He reckons that 10-year euro swap rates might rise to 1.5% at the end of the first quarter of 2019 and perhaps 1.6% at the end of the second quarter. “Some would say that it is a 50% rise, I say that it is only 50bp,” he said.

Certainly, issuance volumes are likely to be maintained or slightly higher.

“I expect Europe next year to be back in net positive issuance,” said Eric Brard, global head of fixed income at Amundi, one of Europe’s largest asset managers with more than €1.4trn of assets under management.

The reason for his bullishness on issuance is that banks certainly need to keep up, or indeed increase, their funding levels for pragmatic and regulatory reasons. More to the point, given that the majority of debt is floating rate, issuers are more concerned about spreads than absolute rates.

So where does this leave buyers? There are still likely to be too few deals to go around and money is likely to continue to chase them. If there is one bright spot in the sights of investors, it is European corporate debt.

“Investment-grade corporates are trading at tight prices and I expect to see some repricing,” said Cherpion. He expects that to kick in in Q1 when the buying power of the ECB disappears. “That represents a serious buying opportunity,” he said.

But as every financier emphasises, careful selection is needed. A blind rush in will not work and it makes sense to evaluate bonds on an individual basis rather than at a country or even at a sector level.

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A brave new world