The Fed will cause an inversion of the US Treasury curve


25 Apr 2018


In March, the most awaited economic data were unemployment figures, in particular the average hourly earnings, which rose by 2.9% YoY (the most since 2009) in January and led to market turmoil on the back of inflation fears.

During the month, reports indicated that average hourly earnings decreased to 2.6%, with the previous figure revised to 2.8%. Surprisingly, all eyes were on the nonfarm payrolls figure (+313’000 job creations) but later in the month, PPI and CPI data confirmed that inflation fears were excessive.

Later in the month, Mr. Trump initiated a trade war, imposing new custom barriers (25% on steel and 10% on aluminum), a controversial decision that led to the resignation of Gary Cohn, the President’s chief economic adviser, and more volatility in financial markets.

As expected, the FOMC finally decided on a rate hike, at the same time amending its economic forecast and increased its growth forecast from 2.5% to 2.7% for 2018, and from 2.1% to 2.4% for 2019 (tax reform effect). The unemployment rate forecast was lowered to 3.8% at the end of 2018 and to 3.6% for 2019 and 2020 respectively, leading to a small increase in inflation projections to 2.1% (just above the 2% Fed target) for 2019 and 2020.

These forecasts are in line with the Fed’s “dot plots”, foreseeing three rate hikes in 2018 (perhaps four, depending on inflation), three additional hikes in 2019 and two in 2020. In Europe, economic data were still in line with expectations, with the markets focusing on the outcome of political elections in Germany and Italy. In Germany, the Social Democratic Party (SPD) agreed to form a government coalition with the CDU based on an indisputable majority (66%). In Italy, the results were less clear, creating a feeling that everybody lost. In any case, the Italian bond market apparently did not suffer from this uncertain outcome.

During the month, Mr. Draghi unveiled the ECB’s new economic forecast. As expected, Eurozone growth was revised from 2.3% to 2.4% for 2018, with inflation projections however staying below the central bank’s target, with 1.4% forecasted for 2018 and 2019, followed by 1.7% for 2020.

As a conclusion, February was dominated by market turmoil due to inflation fears, whereas in March statistics and central banks indicate that these fears were exaggerated in the US and that inflation is not an issue in Europe, which is good news for the long end of yields curves.


During the month, the Investment Adviser added a new name to t he portfolio: Carrefour 2024. More importantly, the team focused on the management of the duration risk, as 30 Bunds were bought back during the month. As a result, the modified duration increased sharply from 0.5 to 1.7. In ter ms of portfolio diversification, the Fund held 29 issues from 29 issuers.


Throughout the month, the Investment Adviser has been actively managing the duration overlay. The team bought back forty 10y Note and five 5y Note futures and further also took the opportunity to continue investing in short term bonds offering a yield close to 3%: More specifically the team invested in Telstra 2021 (3.12%), Toronto Dominion 2021 (3.00%) and Hutchison Whampoa 2022 (3.39%). Finally, the Investment Adviser implemented the “barbell strategy” with the following switch: selling Walt Disney 2022, buying US Treasury 2048 and selling 5y Note Futures (duration neutral switch). The modified duration increased substantially from 3.4 to 4.9 in March. In terms of portfolio diversification, the Fund held 31 issues from 28 different issuers.


The Fund’s duration overlay was managed during the month, in line with the strategy adopted by the Global Bond Fund. The team bought back eighty 10y Note and twenty 5y Note futures, resulting in an increase of the modified duration from 3.2 to 4.8. In terms of portfolio diversification, the Fund held 36 issues from 36 issuers.


The Investment Adviser’s outlook has evolved during the month, however still remains tied to two major topics: inflation and Central Banks’ behaviour. In the Investment Adviser’s mind, inflation fears are currenlty decreasing and the flattening of the US yield curve, combined with other topics such as the near-disappearance of liquidity in the High Yield market, suggest that recession fears will rapidly become a major concern.

In the US market, the Investment Adviser believes that long US Treasuries (10 to 30 years) are becoming increasingly attractive. The team thinks that they could be a top performing asset class in 2018, with an inverted slope of the curve not excluded at the end of the year. In the Investment Adviser’s opinion, the Fed could make mistakes as the markets are not able to absorb other rate hikes. The team thinks that the best strategy currently is to invest in floating rate notes (FRNs), as the 3 month Libor dollar already trades above 2.30%, and short term corporate bonds yielding 3% and above, combined with an investment in 30y US Treasuries.

In Europe, the Investment Adviser thinks that the Bund will finally follow the behaviour of US Treasuries. The team’s former forecast, i.e. a rise of the Bund yield above 0.80%, possibly to a level of 1% at the end of the year, is inconsistent with the flattening (and possible inversion) of the US Treasury curve. As a result, the Bund could stay around its current level, with the Investment Adviser seizing any opportunity during the coming weeks (ideally in April) to buy back some Bund futures in order to decrease the current duration overlay, which could prove more painful in the near future.

In Emerging Markets, the Investment Adviser will continue to closely monitor both, the behaviour of spreads (both government and corporates) and the increasing volatility due to the global risk aversion. The team thinks that high-quality Emerging debt still offers a very attractive risk-reward profile and continues to be supported by low defaults, attractive carry and low supply.

In conclusion, the Investment Adviser still believes that Emerging Market bonds will continue to deliver outstanding returns. The recent market developments nonetheless suggest that the best performing asset class could currently be long-dated US Treasuries.

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 12/04/18 and are based on internal research and modelling.