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Searching out the real fixed income opportunities

Thursday, June 07, 2018

The US bond market has certainly become cheaper in recent months, but GAM Investments' Adrian Owens believes more attractive investment opportunities can be found beyond the US.

The two essential considerations for any investment are: weighing downside risks against upside potential (asymmetries) and finding the optimal market timing.

The former typically incorporates the concept of value: this is currently a huge concern for many investors as most traditional markets have been distorted by Quantitative Easing (QE) and therefore appear to offer little real value relative to history or fundamentals. As a result, investing in these markets arguably carries more risk than usual - downside risk remains significant while upside appears limited.

The real opportunities

The US bond market has become cheaper in recent months, but we think it is important to weigh this potential opportunity against others we currently see. Distortions in markets have created other trades which offer asymmetrical pay offs that are rarely seen, where the downside is limited and the upside potentially huge. In some cases these are the flip side of the effects of QE and as QE is withdrawn these trades are expected to do well. One relates to the unique set of circumstances surrounding Brexit. There are also opportunities stemming from more traditional drivers of markets, such as central bank policy and investor fear.

Here are four examples of such trades:

US yield curve: too flat

As the Fed’s QE programme progressed, the spread between 2 year and 10 year US treasuries became detached from front-end rates. For a given level of short-term interest rates, the curve flattened way beyond what might typically have been expected.

The reason was twofold. First, demand simply exceeded supply. QE flows lowered term premiums, which were ultimately pushed into negative territory. This move was exaggerated by complacency among investors as the outlook for inflation remained benign. Today it is clear that inflation is rising and pipeline pressures continue to build. More importantly, QE has become Quantitative Tightening (QT). Consequently, we expect the US curve will commence re-steepening from today’s historically stretched levels.

Chart 1: US yield curve – too flat

Source: Bloomberg, as at May 25, 2018

Past performance is not an indicator of future performance and current or future trends.

Swedish curve: too steep

Sweden has one of the steepest yield curves in the world at 140bps. This is because the central bank has been very slow to signal a shift to higher rates despite inflation at 2%, growth between 2.5% and 3%, the amount of QE as a percentage of GDP being second only to Japan and short term interest rates at -0.5%. We believe higher rates are coming and when they do the Swedish curve is likely to flatten in its own right and relative to the US. Once this process begins the Swedish krone is also likely to rally from historically cheap levels.

Chart 2: US and Swedish swap curves – extreme divergence

Source: Bloomberg, as at May 25, 2018

Past performance is not an indicator of future performance and current or future trends.

UK fixed Income: too rich

Despite above target inflation and a questionable outlook for sterling (on the back of Brexit uncertainty) UK gilts continue to trade at a premium. At current rates, an investor buying 10 year UK fixed income is guaranteed to make a real loss of 1% per annum – more if you believe that RPI inflation is an accurate reflection of UK prices. Relative to other markets such as Canada the UK trades at record levels of richness despite higher inflation and less favourable debt dynamics. The 10 year bond spread to Canada at around 100bps is the most extreme in over 30 years and at a spread which we believe will be difficult to sustain with or without Brexit.

Chart 3: Canada vs UK

Source: Bloomberg, as at May 25, 2018

Past performance is not an indicator of future performance and current or future trends.

Mexican rates: too cheap

The Mexican story is a simple one. The central bank has hiked interest rates to 7.5% to tackle above target inflation. This has slowed down the economy and inflation is rapidly reverting back to target. The central bank could start to ease policy, but ongoing NAFTA negotiations and a looming presidential election on 1 July mean it will likely bide its time.

Given Mexican-specific uncertainty, and the backup in US rates, Mexican debt has become increasingly attractive. Investors are able to buy long-dated bonds at close to 8% yields or receive 5 year swaps starting in 5 years’ time at close to 8.5%. With inflation at 4.4% and falling, and short-term interest rates likely to be cut around the turn of the year, Mexico is starting to look like the stand out opportunity in the fixed income world. The only real question is whether to buy today or wait for a little more clarity on NAFTA and the presidential elections.

Chart 4: Falling inflation should support Mexican rates

Source: Bloomberg, as at May 25, 2018

Past performance is not an indicator of future performance and current or future trends.

How do these compare against the US?

Weighing these opportunities against those in more traditional markets, we can say that US bond market has certainly become “cheaper” in recent months, thanks to the Fed’s tightening path. Since the summer of 2016, 10 year treasury yields have more than doubled to above 3%. We think this might offer a short term opportunity, and that there may be some retracement in treasury yields: after all, the market has factored in a lot of good news on the economy, investors have increased their short positions in treasuries to record levels, US dollar strength is doing some of the Fed’s work and US 10 year treasuries are delivering a small positive real yield.

But the bigger picture is not so good. While future demand for treasuries is unpredictable we know that supply is set to increase significantly as the year progresses. The US is in the process of moving from a $2tn-a-year asset expansion to shrinkage in the next year. A higher Fed Funds rate has largely been behind the rise in 10 year treasury yields to date, but going forward QT is likely to play a more meaningful role.

In addition, the backdrop (both fiscal and monetary) remains supportive and we expect the current soft patch to be short lived. Many developed economies are operating close to full capacity and this, together with rising oil and commodity prices, suggests that inflationary pressures will continue to rise. So while investors may be due a short reprieve from the constant weakening in US treasuries we believe that over the next 12 months any returns are likely to be uninspiring.


Investors can try to catch a modest potential bounce in US treasuries if they can get their timing right. Or we believe trades such as those outlined above offer limited downside and the potential for significant rewards.

Important legal information
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development.
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