Inflation-linked bonds continue to be a favourite, with the US the preferred market

The month was marked by the fact that very few sovereign asset classes saw positive returns. Emerging markets (hard currency) suffered the most as a result of the spread-widening in the US, especially in the post-Trump election period. The EM local-debt segment also felt some pain, though not as bad as the external debt, thanks to lower duration exposure. The US curve itself was amongst the bad performers and saw significant sell-offs. On the developed-markets front, Canada, Australia and New Zealand were the worst performers, while a relatively less affected Japanese sovereign-debt market offered some decorrelation to the other bond markets. In Europe, non-core countries (Spain Italy and Portugal) were the worst hit, though Greece was the rare positive performer over the course of the month. In relative terms, year-to-date, Belgium and Ireland outperformed France while Spain outperformed Italy.

Inflation-linked bonds continue to be a favourite, with the US the preferred market

Both the US and the Eurozone are in a reflation phase. Wage and consumer sub-indicators are posting solid numbers while the energy segment should also help push headline inflation higher in the coming months. However, we do not believe that this has been priced in by the market yet, as exhibited by the low expectations built into the inflation cash and swap markets both in the EU and in the US. Both markets have seen inflation-linked bonds outperform the nominal ones. Real yields in the US also appear to be much cheaper than UK yields. We continue to favour long-end breakeven positions in the US as a limited inflation premium is built in.

Curve-flattening on US rates

While the base-case scenario continues to point towards rising rates in the US (on the back of better activity and an improved inflation cycle), US treasury yields rose sharply in November. A near-term consolidation is expected as short positioning on the ultra-long-term segment has increased dramatically. On the short end of the curve, we believe that the current market view of 1.5 rate hikes in 2017 appears to be too cautious, considering the monetary policy gauge (we expect 4 hikes over the next 13 months). The short end should hence rise more, inciting us to reduce duration on the 2-year segment, favouring a flattening strategy on the US curve.

Short positions on Core Europe, tactical stance on Non-core

The ECB’s ongoing expansionary monetary policy has been supportive of core European yields. However, the central bank appears to be running out of ammunition for further easing and the efficiency of the current programme is being increasingly questioned. Furthermore, the ECB has announced a reduction of its bond-buying programme (from EUR 80 billion to 60 billion), while extending the duration. Europe could, indeed, follow Japan and the UK and move towards a preference for fiscal rather than monetary stimulus. Inflation pick-up is visible in the Euro area. Stretched valuations continue to be a source of concern and, over the course of the month, core yields climbed higher into positive territory (German 10Y at 0.275% as at end-November) and are likely to continue to do so in the wake of rising US yields. In this context, our framework continues to point to the relative expensiveness of the European core markets, justifying our underweight. This strategy was successful in October and November.

Our stance on non-core sovereigns in the Eurozone is slightly positive. The segment should benefit from ECB flow dynamics (based on the December ECB meeting announcement),  which remain present. Our strategy of being long Spain vs Short Italy has been quite rewarding in the past and we continue to favour a long allocation to Spanish sovereign bonds, while remaining cautious on Italy, which is likely to suffer from the “No” vote in the recent referendum and the political uncertainty that this entails. We aim to continue to diversify our exposure towards Eastern Europe (Latvia, Lithuania, Slovakia).