Bonds caught between hawkish Central banks and political uncertainties


Fund Commentary
20 Mar 2017


In February, US economic indicators were mixed and led by very strong housing data. Inflation remained the big question mark as two contradictory data points were published.

January CPI, at +0.6%, was the biggest monthly gain in four years led by gasoline prices and pushed the YoY inflation index to 2.5% (+2.3% ex-food & energy). On the other hand, the average hourly earnings data declined from +2.9% YoY to 2.5%. Job creations were still solid (+227k) but the unemployment rate increased from 4.7% to 4.8%. The Fed did not change its key rates at the FOMC meeting on 1st February but left the door open for a Fed funds increase in March after the strong CPI data and a more hawkish testimony from Ms Yellen to Congress. She said that “waiting too long to tighten policy would be unwise”. This more restrictive monetary policy will be conducted without Daniel Tarullo who will leave the Fed in April.

In Europe, a strong set of data showed evidence of accelerating growth. At the same time, inflation increased sharply to reach +1.8% and unemployment declined to its lowest level in seven years. As a result, the ECB acknowledged these encouraging signs but Mr. Draghi reaffirmed that there is no plan to end QE. Meanwhile, Greece, the EU and the IMF were still negotiating a plan to avoid default as Greece has to make a EUR 8 billion bond payment in July…

Political events and fears continued to have an impact on markets’ behaviour. In the US, the unconventional behaviour of the new President was still a source of concern but, first and foremost, the markets remained sceptical regarding the level of implementation of his program. In Europe, two key elections could call into question the EU and/or the Euro: Parliamentary Elections in the Netherlands on 15th March and the Presidential Election in France on 23rd April and 7th May. Mr. Wilders and Ms Le Pen are seen as a threat to financial markets and the political stability of Europe.

In this context, the 2y US Treasury yield increased from 1.20% to 1.26% (+6bps), the 5y from 1.91% to 1.93% (+2bps), while the 10y decreased from 2.45% to 2.39% (-6bps) and the 30y long bond went from 3.06% to 3.00% (-6bps). At the same time, the 30y inflationlinked Treasury yield decreased from 0.93% to 0.91%, leading to a small reduction of the inflation breakeven from 2.13% to 2.09%. Last but not least, the 3 Month USD LIBOR reached 1.0640% at the end of the month. In Europe, the German curve rallied substantially due to a “flight to quality”, the 2y yield decreasing from -0.70% to -0.90% (-20bps), the 5y yield from -0.40% to -0.57% (-17bps) and the 10y Bund from 0.44% to 0.21% (-23bps). At the same time, the French 10y OAT yield “only” decreased from 1.03% to 0.89% (-14bps), the Italian BTP 10y yield decreased from 2.26% to 2.09% (-17bps) while the Spanish 10y bond yield climbed from 1.59% to 1.64% (+5bps). On the credit side, the European iTraxx Main hardly moved from 74 to 73bps while the US corporate CDX index decreased from 67 to 62bps. In Emerging Markets, the CDX 10y EM index rallied from 291 to 274bps (-17bps).


During the month, the Investment Adviser took the opportunity of the rally to build a short position on the Bund and Bobl Future markets. At month end, the Fund was short 60 Bund contracts and 20 Bobl contracts. As a result, the Modified Duration decreased sharply from 2.3 to around 0.8. In terms of portfolio diversification, the Fund held 36 issues from 35 different issuers.


During the month, the Investment Adviser took the decision to build a short position in the 10Y Note Future market. He also built a 10-30y flattening strategy (neutral duration), selling USD 2 million US treasury 2026, buying 2 million US treasury 2047 and selling 30 10y Note Futures contracts. He also started to decrease the weight of the Portuguese EDP and the Italian Enel. He continued to favour investments in Floating Rate Notes, switching Roche fixed into Roche FRN. Finally, he partially sold Ford, Toronto Dominion, Engie and Linde due to their weightings increasing close to 5%. As a result, the modified duration decreased from 3.5 to around 2.9. In terms of portfolio diversification, the Fund held 41 issues from 37 different issuers.


In February, the Emerging Market bond market continued to rally and deliver exceptional performance. Consequently, the Investment Adviser decided to take profit on high beta countries and issuers, switching into low beta names. Turkey and Azerbaijan were totally sold, Russia decreased from 19% to 11%, Brazil from 11% to 8%, Colombia from 4% to 1%, Mexico from 5% to 3.5% and South Africa from 3% to 2%. Three new countries appeared in the portfolio: Slovakia, Latvia and Luxembourg (the headquarters of ArcelorMittal). The positions in China, Hungary, India, Lithuania, Peru, Poland and Romania have been increased. In addition, in line with the strategy implemented in the Strategy Global Bond Fund, a short position in 10y Note futures was built. In terms of geographical breakdown, the top 3 countries were Russia (11.1%), India (10.3%) and China (9.8%). The rating allocation was 64.9% Investment Grade (against 49.8% in January) and 34.0% Crossover BB+ and BB (against 47.1% last month). The breakdown of the portfolio in terms of market allocation was 97.7% Emerging Markets, 1.1% Developed Markets (i.e. Luxembourg/ArcelorMittal) and 1.2% cash. In terms of sector allocation, the Investment Adviser favoured Governments (47.0%) followed by Materials (16.2%) and Energy (14.6%). The modified duration decreased significantly from 5.8 to 4.6 during the month. In terms of portfolio diversification, the Fund held 34 issues from 34 different issuers.


The Investment Adviser’s global outlook has become very cautious. The sell-off in the Treasury market could continue in the coming weeks and the spread between the 10y US Treasury and the German Bund could narrow from almost 200bps today (which is a record high) to its long term average around 160bps. This means US bonds could suffer substantially in the coming months but European bonds could be even more at risk. Should 10y Treasuries increase to 3% and the spread Treasury-Bund tighten at the same time, the 10y German yield could potentially rise above 1%. This worst case scenario could be possible under three conditions: the improving economic situation in Europe, the uncertain (and potentially dangerous) outcome of elections in Netherlands and France and finally a possible key change in the behaviour of Mr. Draghi, preparing markets for tapering in January 2018. This means that the coming weeks will be crucial for the three bond funds and the Investment Adviser will continue to take any opportunity in the markets to decrease the duration risk of the portfolios through the use of short Futures. On the other hand, all these hedges against higher US and German yields could be removed immediately if the US economy shows the first signs of slowdown and/or equity markets start to fall. In addition, the Investment Adviser will closely monitor the evolution of high beta Emerging Markets in order to seize any opportunity to reinvest in these regions once a correction has materialized.


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 14/03/17 and are based on internal research and modelling.