A huge bond sell-off driven by Trumponomics, but not only


Fund Commentary
22 Dec 2016


In November, markets were driven by the US presidential election outcome and the victory of Donald Trump. Against all odds, stocks rallied and safe havens such as gold and bonds underperformed dramatically. The most frequent argument used to explain this behaviour is that Mr Trump’s policies will spur growth and favour inflation.

Mr Trump’s program contains many uncertainties: what exactly is his program? Will it be implemented? How many years will we have to wait to see the first results? Will the majority of Republicans in Congress vote for some of the more controversial measures? It is too early to develop a new economic scenario and the US economy will not change dramatically in the coming weeks or months.

Just after the announcement of Trump’s victory, markets’ behaviour was logical: a Treasury rally (30y at 2.52%), gold above 1330, a Swiss franc rally reaching 0.9550 against USD, S&P futures at the limit down (-5%). Then, all these markets turned, with equities rallying substantially and safe havens starting to decrease. In this environment, the only behaviour which seemed “normal” was the drop of some Emerging currencies (the Mexican peso being the most emblematic) and the widening of Emerging market bond spreads. This Treasury sell-off has been massively amplified by record volumes of transactions. The decrease of the bond markets (i.e. the increase of bond yields) can be explained by an accumulation of massive sell orders. Initially, market participants thought that these orders came from China but on further analysis, the origin of these trades appeared to be Hedge Funds and CTAs leading the market action with high-frequency trading primarily responsible for an amplification of the sell-off.

In this context, the US Treasury curve experienced a huge bearish steepening, the 2y US Treasury yield increased from 0.84% to 1.11% (+27bps), the 5y yield from 1.31% to 1.84% (+53bps), the 10y from 1.83% to 2.38% (+55bps) and the 30y long bond from 2.58% to 3.03% (+45bps). At the same time, the 30y inflation-linked Treasury yield climbed from 0.70% to 0.92%, pushing the inflation breakeven rate from 1.88% to 2.11%. In Europe, German bonds behaved differently: the 10y Bund was hit by the sell-off in Treasuries but the short end of the curve rallied when market participants realised that a brutal tapering from the ECB in March 2017 was not an option. Consequently, the German yield curve steepened (2y-10y slope by 23bps), the 2y yield decreasing from -0.62% to -0.73% (-11bps), the 5y yield from -0.40% to -0.43% (-3bps) and the 10y Bund yield increasing from 0.16% to 0.28% (+12bps). At the same time, the Italian 10y yield increased from 1.66% to 1.99% (+33bps) while the Spanish 10y bond yield rose from 1.20% to 1.55% (+35bps). On the credit side, the European iTraxx Main slightly increased from 73 to 80bps while the US corporate CDX index decreased from 79 to73bps due to the socalled beneficial effects of “Trumponomics”. In Emerging Markets, the CDX 10y EM index “only” widened from 290 to 308bp (+18bps) after reaching a peak of 332bps on 14th November.



During the month, the Investment Adviser did not modify his new strategy that was implemented in October, favouring investments in Floating Rate corporates (non-Financials), i.e. bonds with low duration (between 0 and 0.3) and coupons indexed to the 3 month Euribor. The duration was maintained around 2.5. In terms of portfolio diversification, the Fund held 37 issues from 36 different issuers.



During the month, the Investment Adviser applied the same strategy which has been followed in the Euro Bond Fund since October. Due to the behaviour of the market recently and the increasing probability of tensions in the inter-bank market, the Investment Adviser started to build a significant proportion of the portfolio (around 6.7% at Month end) in Floating Rate Notes (mainly non-Financial corporates), i.e. bonds with low duration (between 0 and 0.3) and coupons indexed on the 3 month USD Libor. Consequently, he bought the following FRN bonds: Ford Motor Credit 2018, Apple 2018, Cisco 2018, Siemens 2018, Exxon Mobil 2018, Toronto Dominion 2018 (the only financial issue), Roche 2019 and Nissan 2019. Regarding the sell-off in the 30y Treasury market, the Investment Adviser had previously identified two major stop-loss levels: 2.81% and 3.13%. Once the yield climbed above this first level, he sold half of the position in 30y bonds at 2.84% (and a small position at 2.99%). Consequently, the position in 30y Treasuries decreased substantially from $8m to $3.5m but the investments in TIPS (inflation-linked) were retained. The proceeds of this sale have been reinvested in short term corporates (Toyota 2017, RCI banque 2018, Honda 2018 and Pfizer 2019). Finally, due to a weight approaching 5% of the portfolio, positions in Engie 2017, Linde 2018 and EDF 2019 were reduced. The modified duration decreased from 6.0 to 4.8 and could be decreased substantially in December should 30y Treasury yield climb above 3.13% (the second stop-loss level that would trigger the sale of the remaining stake in long bonds). In terms of portfolio diversification, the Fund held 44 issues from 38 different issuers.



In November, the Investment Adviser increased the weight of Mol 2019 and sold the whole position in Eskom 2021 due to a possible lack of support from the South-African government that could lead to a multiple-notch downgrade. A small position ($1m) in the 30y US Treasury was sold at 2.84% (the stop-loss level). In terms of geographical breakdown, the top 3 countries were Russia (18.8%), Brazil (10.1%) and India (7.7%). The rating allocation was 45.8% Investment Grade and 49.2% Crossover (BB+ and BB). The breakdown of the portfolio in terms of market allocation was 92.3% Emerging Markets, 2.7% Developed Markets (US Treasuries) and 5.0% cash. In terms of sector allocation, the Investment Adviser favoured Governments (34.0%) followed by Energy (17.0%) and Materials (16.9%). The modified duration decreased from 6.4 to 5.8 during the month. In terms of portfolio diversification, the Fund held 37 issues from 36 different issuers.



The Investment Adviser’s global outlook has not changed for the moment. Mr Trump is not a magician and during his 4-year mandate, the US will not avoid a recession or at least a significant slowdown. In terms of growth, the trend will remain broadly the same. Regarding inflation, reflation is unlikely in the Investment Adviser’s opinion. Since Mr Trump’s victory, the US and China are at war; Trump’s protectionist measures won’t be implemented because China will use two “nuclear weapons”. First and foremost, they can sell trillions of Treasuries, an unprecedented sell-off leading to recession and stock market collapse. Secondly, if Mr Trump really wants to tighten the rules and increase rates of customs duty, China will immediately reply with a brutal devaluation of the yuan (bear in mind the reaction of the stock market to the soft devaluation in August 2015). More generally, China is still a huge deflationary contributor. To summarize the Investment Adviser’s thoughts about the behaviour of the bond market today, he strongly believes that it resembles the Taper tantrum from June 2013. The sell-off in the Treasury market could continue and, as of today, there is a 50% probability that Treasury yields have already reached a top and a 50% odds that the yield increase will continue for a few weeks (with possibly the 10y yield between 2.5% and 2.7% and the 30y at 3.3%). Should US Treasuries reach these levels, this would represent a fantastic buying opportunity. This is the reason why the Investment Adviser is extremely cautious with his short term tactical management while his long term strategy remains the same; the recent sell-off is probably a correction in a bull market. Regarding Europe, The ECB must maintain its policy (massive QE) as we will see the first real consequences of Brexit in one year (probably Q4 2017). In the US, the Fed will raise the Fed funds rates on December 14th but Ms Yellen will probably stay dovish during the press conference. The Investment Adviser still believes that the Fed needs to raise rates, not because the US economy is performing well (and will perform even better with Trumponomics) but because the US Central bankers are scared by a possible slowdown in 12-18 months while their toolbox is empty. Emerging Markets will stay volatile but technical factors such as low net issuance, the negative or low yield environment in most Developed Markets, higher commodity and oil prices (OPEC’s behaviour is bullish for Emerging bonds), stabilisation of emerging currencies and a “not-too-hawkish” Fed suggest that the environment will remain supportive for further spread tightening. Any correction would be a buying opportunity.


The views and statements contained herein are those of the Eric Sturdza Banking Group in their capacity as Investment Advisers to the Fund as of 14/12/16 and are based on internal research and modelling.