The yield on Treasuries has gone up a lot the last week. This should make us more bullish on the bond market. After all, today, those with fixed income in their portfolios receive a higher return than in recent years. Furthermore, higher yields protect the portfolio from price volatility, much more than they did when contained by global central bank buying.
They are naturally higher in the US because the economy is booming and the Federal Reserve is raising rates. For these reasons, the risk is that yields will rise again. But the effect on overall return is small as yields rise and, at some point, when the risk cycle reverses, investors will be happy to have fixed income in their portfolios. Particularly in dollar-denominated portfolios. The dynamics may be similar in Europe, but ultimately bond yields need to rise further and from a lower base. For this reason, it is not so easy to be bullish on European fixed income.
Concerns remain, but shorter dated US bonds are attractive
So with a yield of 3,2% it's more comforting to be bullish on Treasuries today than it was when the yield was below 1,5%. For a 10-year exposure, an increase in yield to 4% from current levels would still result in a rather negative overall return of just under 4%. But this takes into account a loss of 4,4% (in the event of a comparable change in yield) 6 months ago, and more than 6% since the minimum level of yield in July 2016.
Recall that the US curve is very flat, there is only a 30 bp difference in 2-year yields versus XNUMX-year yields. So being more bullish on US fixed income today is probably best reflected in the 10-year downside curve. But should yields hit 4%, the longer-term segment would look better. Not only because of the yield, but also because of its subsequent implications.
Rates go up and credit spreads widen
One possible evolution of the fixed income cycle is one in which real rates and yields rise on the back of robust growth and appropriate monetary policy intervention in response to rising inflationary pressures. On the other hand, the increase in real yields could have a negative impact on the instruments most exposed to risk. First, the risk-free rate becomes competitive, so the riskier alternative instruments must undergo a consequent repricing. Second, the increase in real yields will have some impact on the real economy through an increase in the cost of capital, making some investment projects unprofitable. Not to mention the rising cost of servicing debt in the leveraged parts of the economy.
As economic growth slows, it becomes more difficult for stocks to continue rising, while the ability of companies to service debt decreases. Therefore, risk premiums will have to rise and the instruments most exposed to risk will show lower performance than rates risk free. When the economic slowdown becomes apparent, the market will discount and eventually get lower interest rates, driving up the yield on fixed income.
Don't be too bearish, it's about rates
This line of thought leads us to conclude that, when Treasury yields rise, investors should be more bearish on credit and more bullish on rates. It looks like an approach accidentally contrarian, however it makes sense in the future. Global credit spreads have widened this year, but not much, except in emerging markets. And they shouldn't have, given the positive macroeconomic scenario and the capital solidity of the companies.
Credit has already outperformed over the past 3 months (globally and individually in key investment grade markets in the US, Eurozone and Sterling). We will probably still wait for a significant widening of credit spreads and a decline in rates. And before that actually happens, stocks will need to start underperforming.
However, sooner or later it will happen. In the near term it could be reflected in the sensitivity of markets to “risk” events. Events in Italy gave us an idea last week. It could happen as trade tensions between China and the United States escalate. Investors may already be quoting yields above 3% in the US and think it "wouldn't be too bad for a safe haven" as stocks are subject to sudden changes in fundamental outlook on a nod from President Trump. The recent re-emphasis on the issue of "national security" in the Sino-US dispute should already be a cause for concern.
October?
Credit default swap spreads for emerging markets, US high yield and crossover credit in Europe have widened in recent sessions indicating a return to risk aversion. October is one of those months where strange things happen in the markets. While I don't believe these catchphrases, there are enough investors who do believe that volatility could pick up towards the end of the year. It certainly wasn't a good year for fixed income, e it seems highly unlikely that further investing in high yield or credit at this stage will make a big positive difference.
The situation in Europe is certainly different than in the US, but the dynamics could still be the same in the event of a period of risk aversion. All things being equal, il Sell-off of global bonds since mid-August, and the recent hike in Treasury yields in particular, should prompt investors to have a little more safe bonds in their portfolios.
