US 10 year yield reaches 3%. So what?


23 May 2018


In April, the trade war between the US and China was still a matter of concern. In addition, a wave of new US sanctions against Russia led to a rally in the commodity markets, with Aluminum leading the trend with a surge of 14% on the back of sanctions against the Russian producer Rusal.

In the US, the most awaited economic statistic was still unemployment data, annual average hourly earnings in particular, which increased from 2.6% to 2.7% in March. The nonfarm payrolls figure (+103’000 job creations) was disappointing, whereas the GDP grew by more than expected, +2.3% during the first quarter.

In Germany, the ZEW index was particularly low, with the “expectations” component falling sharply from 5.1 to -8.2 following fears surrounding the negative impact of a trade war on economic growth in Germany. According to the Investment Adviser inflation was still (too) low, standing at 1.6% in Germany and 1.4% in the European Union. Throughout the month, the ECB meeting revealed a more cautious and pragmatic stance. The Quantitative Easing program is supposed to end in September but, if necessary, could be extended. As a result, the US 10y Treasury yield climbed to 3.03%, before declining to circa 2.95% at the end of the month. The key technical level, 3.05%, has so far not been broken and a correction down to 2.84% in May appears likely in the Investment Adviser’s opinion.


During the month, the Investment Adviser focused on managing the duration risk, with 10 Bunds having been bought back during the month. As a result, the modified duration increased from 1.7 to 2.0. In terms of portfolio diversification, the Fund held 29 issues from 29 issuers.


In April, the Investment Adviser bought back twenty 5y Note futures, resulting in an increase of the modified duration from 4.9 to 5.4. In terms of portfolio diversification, the Fund held 29 issues from 26 different issuers.


During the month, the team focused on managing the Fund’s duration overlay in line with the strategy adopted by the Strategic Global Bond Fund. The Investment Adviser bought back forty 5y Note futures. As a result, the modified duration increased from 4.8 to 5.3. Following the uncertainties around Russian debt issued in US Dollar in the context of new sanctions, the Investment Adviser decided to sell the whole position in Russian issuers (11%) including Gazprom, Severstal, Norilsk Nickel and Phosagro. The team reinvested in six existing bonds, increasing their weights respectively: Tencent 2020, Ecopetrol 2023, OCP 2024, Enel Americas 2026, South Africa 2027 and Indonesia 2048. In addition, three new names have been added to the portfolio: Comisiòn Federal de Electricidad 2027 (Mexico, Utility), Indonesia Export-Import Bank (Indonesia, Government Agency) and Perusahaan Gas Negara 2024 (Indonesia, Oil & Gas). In terms of portfolio diversification, the Fund held 35 issues from 35 issuers.


The Investment Adviser’s outlook remains tied to two major topics, inflation and Central Banks’ behaviour. Inflation fears however keep 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 the second half of 2018 and that an inverted slope of the curve is not excluded prior to year end. In the Investment Adviser’s view, the Fed could make mistakes given that the markets cannot absorb additional rate hikes. The team believes that the best strategy currently is to invest in both, floating rate notes (FRNs), as the 3 month Libor dollar is already above 2.30% and short term corporate bonds yield 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% and possibly 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 remain at its current level.

In Emerging Markets, the Investment Adviser will continue to closely monitor the behaviour of spreads (both governments and corporates) and increasing volatility due to global risk aversion. This market has suffered in April due to US sanctions against Russia and the strengthening of the US dollar. The month of April has been the worst since November-December 2016 (Donald Trump’s election) in terms of performance. 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 but the recent market developments suggest that the best performing asset class, as of now, could 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 08/05/18 and are based on internal research and modelling.