BONDS

Shift from a “central bank put” to a “presidential put”

The investor environment is moving away from comfortable reliance on central banks that are able and willing tosupport asset prices and toward governments that appear less constrained by Parliaments in pursuing pro-growthpolicies.

For much of the period since the 2008 global financial crisis, markets have been able to rely on central banks torepress financial volatility and boost asset prices - as a conduit to higher growth and faster balance-sheet repair. Therise in central bank balance sheets has pulled up global stocks. The MSCI All-Country World index of shares roseto a new record last month, after the combined assets of the Federal Reserve (Fed), the European Central Bank (ECB)and the Bank of Japan (BoJ) reached an unprecedented 11.1% of global gross domestic product.

But the Fed - using the public reasoning of higher global growth and inflation - seems now set to resume graduallylifting its foot off the accelerator. The Fed’s decision to raise last month interest rates from 0.75% to 1% but staywith a gradual increase guidance led traders to boost the odds for the central bank to meet its projection for a total ofthree hikes this year (96%).

The Fed is not the only systemically important central bank that may be in transition mode, particularly given thegrowing awareness of the potential costs and risks of remaining too loose for too long.

China’s central bank raised borrowing costs as a stable economy and factory reflation give it scope to follow theFederal Reserve in tightening policy. As a result, China bonds and Treasuries are moving together. That is thereverse of the previous two years, when the debt markets of the world’s largest two economies diverged.

MARCH 2017

The analysis of Thierry MassetLagging assets are playing catch upShift from a “central bank put” to a“presidential put”The curbs by OPEC aren’t enough toclear the surplus in oil inventoriesItaly is biggest threat to EuroEarnings revisions turn positive for thefirst time since 2011Rhodium accelerates like a rocket

For its part, the ECB, which is scheduled to end its bond buying in December, has come under increasingpressure to consider reducing its balance-sheet support for markets as a prelude to abandoning negative policyrates.Meanwhile, the governor of the BoJ has publicly questioned the continued effectiveness of a pedal-to-the-metalapproach to unconventional monetary policy and has shifted its focus toward targeting bond yields in order tosteepen the yield curve.

This change has not been of major concern to markets because of the presidential put - that is, the markets’willingness to embrace prospects for pro-growth policies under the new Trump administration. This is due to two factors:repeated comments by President Donald Trump signaling his intention to pursue the trifecta of pro-growth measuresinvolving deregulation, infrastructure and tax reform; and the reduced threat of paralyzing political gridlock on Capitol Hill. Thatexplains why the difference between the S&P 500 volatility index — a gauge of investor anxiety, commonly known as the VIXindex — and the Global economic policy uncertainty index is at a record high, underscoring how global equity markets haveshrugged off surging policy risks.

Markets have yet to internalize the multiple dimensions associated with the simple fact that the “presidential put”is a different type of “put” than the “central bank put.”

On the positive side of the ledger, for example, transitioning from overreliance on central banks to a broader policyresponse has the potential to generate higher and more inclusive growth, as well as strengthen the underpinnings ofgenuine financial stability. Both of these would help validate existing asset prices and even push them higher over timein a sustainable fashion.On the negative side, however, the new policy construct is less autonomous when it comes to implementation.Unlike the Fed, which can pursue measures without congressional approval (though that offers a significantly narrowerpolicy set), the president Donald Trump needs congressional approval for a lot of what he has suggested for promotinggrowth. And such approval is subject to influences that go beyond the merit of the measures themselves. As anillustration, there is some concern that the administration's taking on health care ahead of tax reform means theimplementation of an important item of the pro-growth agenda could be delayed by political divisions over the effort torepeal and replace Obamacare.

The “central bank put" was extremely supportive of asset prices for several years. For the “presidential put” to besimilarly beneficial, good policy making by the Trump administration would not prove sufficient unless it isaccompanied by sound economic governance by Parliament.

That being said, protectionism and a fiscal boost – with Donald Trump’s promises of tax cuts and $1 trillion ininfrastructure spending -, combined with a U.S. economy operating close to full employment, raise the possibility ofhigher inflation and larger inflation surprise. In this context, we prefer to keep our careful approach on the bondmarket (sovereign and credit), especially in the Euro-Area where the anti-globalisation narrative constitutes ahandicap (more comments in the Euro-Area bonds section).

Higher inflation and higher interest rates carry unprecedented risk for global bonds, according to the modifiedduration (the measurable change in the value of a bond in response to a change in interest rates) of Bloomberg BarclaysU.S. and global Aggregate Bond indices, which showed a rate change of 1% would trigger respectively a 6% and 7% swing intheir value, their highest reading since calculations began in 1989.

In this context, there is a risk of a selloff of essentially longer-end securities! From Austria to Ireland, governmentshave sought to lock in lower borrowings costs for longer. Rather than the usual pension funds that tend to buy and hold,though, a wider pool of investors snapped them up as they sought to generate returns. That potentially increases the chancesof a sharper decline. The longer-dated bonds don’t qualify for ECB purchases, but the risk is that the whole marketwould tumble if QE were reduced and shorter yields might become more attractive.

2.1 Inflation-linked bonds: overweight

The glow of quantitative easing (QE) is fading and traders are fast adding to bets that the Fed will go on raising

The glow of quantitative easing (QE) is fading and traders are fast adding to bets that the Fed will go on raisinginterest rates amid strengthening economic data and inflationary infrastructure plans announced by Donald Trump.

The Bloomberg U.S. economic surprise index - which measures whether economic data have exceeded or fallen shortof analysts’ estimates - has surged during the previous two months and is now positive for the first time since August.

A gauge of U.S. inflation expectations from the Fed, known as the five-year, five-year forward break-even rate, projectsconsumer prices will climb at a 2% annual pace from 2021 to 2026, close to the highest level since May.

The prospect of lower corporate taxes, repatriation of overseas cash, reduced regulations, and fiscalstimulus has already led investors to expect positive earnings per share revisions as the U.S. annualized grossdomestic product rose 3.2% in the third quarter, the most in two years, and 1.9% in the fourth quarter, whileunemployment (4.8%) hit a nine-year low in January.

At the same time, speculation is mounting for the European Central Bank (ECB) and the Bank of Japan (BoJ) totaper their asset-purchase programs, as expressed by the steepening of the yield curve. As a result, the spread

between 30-year and 5-year yields is rebounding after contracting in August to the narrowest since the first quarter of 2015. Itwas at the end of last month around 1.1% in the U.S., 1.5% in Germany and 0.97% in Japan up from as little as respectively1.03%, 0.9% and 0.5% at the end of August.

Central bank asset purchases have exacerbated the danger in bond markets by forcing investors to seek yield in longer-dateddebt, which is more sensitive to changes in interest rates and inflation expectations than short-term notes. That explains whytraders are now favouring shorter maturities of sovereign bonds as central banks are seen as potentially stokinginflation, which erodes the value of debt maturing decades in the future. A “strengthening inflation pulse” will lead investors tolook at the absolute levels of yields provided by 10-year sovereign bonds and ask “does that actually make sense net ofinflation?”

The question is especially relevant in the U.S. and in the United Kingdom where bond buyers are worrying aboutinflation. The 10-year Treasury and Gilt notes yield respectively 2.5% and 1.25%, from a record-low 1.318% in July and0.51% in August.

While the pound has fallen near its weakest level since 1985, expectations for U.K. inflation over the next decade havealready surged to the highest since May 2014, based on a bond-market gauge. The 10-year break-even rate, derivedfrom the yield difference between conventional gilts and those linked to retail-price inflation, has spiked to 3.3% from2.3% on June 22, the day before the U.K. voted to leave the European Union, according to data compiled by Bloomberg.In the U.S., the 10-year break-even rate rose as high as 2%, a level unseen since May 19, while the Fed targets 2%inflation.

As Donald Trump and his inflationary infrastructure plans have steepened the yield curve more in few months thanthe Federal Reserve (Fed) has in years, U.S. inflation-linked debt will continue to attract those looking for a haven(the Bank of America Merrill Lynch global survey shows the largest-ever inflows to Treasury Inflation Protected Securities inthe past months).

It's a different dynamic in Europe, which, like the U.S. and much of the rest of the world, has been caught in a deflationtrend for years. But if the world's largest economy looks set to buck that trend, it is more likely that Europe will getswept along and follow suit. The question is in the timing. It may be too early for Europe to get ready for an inflation spikewhen there is such little prospect of growth. This is reflected in the relative performance of breakeven rates, a measure basedon the pricing of nominal and index-linked bonds that rises when expectations for faster price gains pick up. But the incrediblefixed-income rout in the U.S. points to the end of Europe's bond bubble, and its dalliance with ever more negative yields.Perhaps the continent's inflation-linked bond market could do with a closer look.

In this context and to take also into account the recent surge in commodity prices, we have bought short maturitybonds that protect against inflation amid the risk consumer price gains will exceed the target (2%) of the Fed and

BoE, while we keep our underweight positioning on bonds. Long bonds (maturity of at least 10-year), which get hurtmost when inflation picks, have fallen 12% (in euro) in the U.S. and 8.5% in the Euro-Area during the last three months of2016, their steepest decline since June 2015. By contrast, linkers in the Euro-Area have fallen 4%, but still have returned 5%(in euro) in 2016.

2.2 “Peripheral” sovereign bonds in the Euro-Area: neutral (versus “core” sovereign bonds)

Investors looking to the Netherlands for a new political tremor of a similar scale tothe Brexit vote or Trump’s victory have been disappointed.

Prime Minister Mark Rutte, from the People’s Party for Freedom and Democracy (VVD) has easily beaten the anti-Islam Freedom Party of Geert Wilders in last month’s election, allayingconcerns about the spread of populism in the currency bloc.In any case, the Dutch population seems unwilling to dump the euro. The results of the Euro Barometer from Octobershow that 61% of voters think the euro is a "good thing" for their country, compared with 28% regarding it as a "badthing."That explains why the Dutch 10-year spread against Germany has widened slightly (30 basis point) but remains in linewith the average of the past few years (around 25 basis points).

By contrast, the French spread is closer to 65 basis points, signaling an increase in hedging against the politicaluncertainty, a kind of “Le Pen premium”. Investors are clearly taking presidential hopeful Marine Le Pen and her Frexitplans — however unlikely — more seriously than Wilders’ Nexit bet. The scandal threatening to Republican candidateFrancois Fillon's run for the presidency has raised concerns that Marine Le Pen, the populist who wants to withdraw Francefrom the euro, may have less of a long shot at winning. While the latest polling shows that Le Pen would probably make itthrough to the May round, only to lose to Emmanuel Macron (if no candidate gets more than 50% of the vote, a second roundwill be held on May 7), the risks mean investors are suddenly much more eager to take out some insurance against priceswings. While the chances of anti-euro candidate Marine Le Pen winning the second round on May 7 are slim and even if shedoes, the National Front party leader is unlikely to get a majority in the legislative vote in June, we see clear evidence thatelectoral risk has been repriced in the French government bond markets.

In Italy, a failed referendum, a constitutional ruling on voting and concerns about the banking sector raised thelikelihood of an election next year have the same effect then in France: the risk premium of the 10-year Italiansovereign bond has increased to 2% from 1.6%.

Greece is also back in the headlines as it struggles to free itself from a disagreement between the InternationalMonetary Fund and Europe. Once again, the country has to make a debt repayment in the summer and it will probablyneed help to cover the cost. Even if that is resolved, long-term challenges such as reforming the economy and getting peopleback to work remain. Unemployment was unchanged at 23% in December, more than twice the Euro-Area average, and theIMF said that the rate “is expected to stay in the double digits until the middle of the century.”

These sudden moves are reminiscent of swings seen during the debt crisis, when so-called bond vigilantes used to prowl themarket dispensing fiscal discipline by forcing up borrowing costs in countries they saw as erring from the right path. Whilecentral bank policy had largely nullified their power, or at least shifted their focus to the currency market, speculationmonetary stimulus may be nearing its endgame is making the bond market more susceptible to political risks.

As, in the same time, protectionism and a fiscal boost – with Donald Trump’s promises of tax cuts and $1 trillion ininfrastructure spending -, combined with a U.S. economy operating close to full employment, raise the possibility ofhigher inflation and larger inflation surprise, we prefer to keep our careful approach on the sovereign bondsmarket, especially in the Euro-Area where the anti-globalisation narrative still constitutes a handicap.

2.3 Emerging Markets (EM) bonds in hard (neutral => overweight) & local currencies (underweight =>

neutral)

In a global bond selloff fuelled by expectations that Donald Trump will increase government spending, EM bond traders arenot capitulating. While bracing for the risks of protectionist policies (Donald Trump pledged on the campaign trail to pullAmerica out of the Trans-Pacific Partnership, brand China a currency manipulator and build a wall along the border withMexico), they are betting faster growth and narrowing current account deficits will help most developing countriesweather the rout. Thanks also to a less hawkish Fed, bonds of developing nations paid 3.1% more than Treasuries toreward traders for the risk of holding them.

The selloff in EM bonds after Donald Trump’s U.S. presidential election was intense but since the November 8election, developing-nation bonds have more than limited the damage (+1.3% in local currencies and +3% in hardcurrencies).

One reason is that emerging countries are on a stronger footing now compared with three years ago during the so-called taper tantrum when then Federal Reserve Chairman Ben Bernanke’s signal to reduce monetary stimulus sent ashock wave through global markets. Developing-nation local-currency bonds lost about 16% in less than four months.

Economic growth is picking up this year for the first time since 2010 with Brazil and Russia digging themselvesout of recessions, the International Monetary Fund estimates. And we know that an environment where global yieldcurves are steepening is not necessarily negative for EM bonds if paired with an accelerating growth environment.The average shortfall of current accounts in South Africa, Brazil, Turkey, India and Indonesia, a group branded asthe “fragile five” by Morgan Stanley in 2013, has shrunk to 2.4% of gross domestic product, from a record 5% in2013, according to Bloomberg.Foreign reserves have increased in countries including Indonesia and India, providing them with ammunition todefend their currencies.The yield differential between EM local debt and the European yields is at a multi-year high (5%).EM has been sold off for many years and people have very light positions on EM bonds.Finally, a period of uncommonly low volatility of EM currencies also makes attractive carry trades withemerging currencies. Stability makes it easier for investors to borrow in low interest-rate developed markets and buylocal-currency government debt that yields on average about 3% more than comparable U.S. Treasuries. The Fed’srates hikes are already priced in, so there is no additional strength for the dollar, and EM currencies lookcheap at the moment.

2.4 “Investment Grade” and “high yield” corporate (ratings below “BBB-”) bonds: neutral =>

underweight

Demand for credit assets could be approaching a turning point as the price of oil slides below 50 USD/barrel andas the valuations of Investment Grade (IG) and High Yield (HY) debts became rich. The risk premium of European HYbonds has increased from 1,9% to 2.1%, while the risk premium of European IG bonds is hesitating around the symbolic levelof 0%.

Is this just a short-term correction or the beginning of a more structural shift? Will it be contained in U.S. markets,or does it portend greater global risk?

The case for investing in credit risk arguably is less strong as markets brace for the Fed to raise rates. Demand forcredit may be tested if central bank efforts to quash future inflationary pressure end up choking economic growth.The longest slump in the price of crude since the U.S. presidential election has also jolted markets - splintering thecalm that had delivered mammoth gains for debt investors over the last year. Now, some of them are heading for theexits as they look to pocket the gains and sidestep any concerns over a repeat of the commodities plunge that wreakedhavoc on credit markets the last time around.

With borrowing costs on corporate debt hovering around the lowest level since the 2008 crisis, money managers are buyingprotection against losses, while junk-bond funds posted the biggest redemptions since November. Panic or not, the largestjunk-debt exchange-traded fund posted its biggest outflow this year in the past week as investors yanked more than $2 billionfrom BlackRock Inc.’s iShares iBoxx High Yield Corporate Bond ETF.