BLACKROCK INVESTMENT INSTITUTE

Sticking to the short end (for now)

22/okt/2018
By BlackRock

Key points

  1. We maintain our preference for short-term bonds even after the rise in long-term yields.
  2. Global equity markets stabilised after last week’s selloff. The Italy versus Germany government bond yield spread hit the widest in over five years.
  3. This week marks the peak of third-quarter earnings season in the US. The impact of trade conflict and a stronger dollar will be in focus.

Sticking to the short end (for now)

Long-term US Treasuries have led a global government bond selloff over the past few months. Is it time to add exposure to longer-term bonds, as prices have fallen and yields risen? Not yet, we think. We see reasons to stick with shorter-dated bonds for now, even as some opportunities arise in intermediate- and long-term debt.

Chart of the week

Changes in government bond yields, August to October 2018.

Chart of the week

Past performance is not a reliable indicator of current or future results. It is not possible to invest directly in an index.
Sources: BlackRock Investment Institute, with data from Bloomberg, October 2018.
Notes: The bars show the changes in yield for 2-year (2Y) and 10-year (10Y) benchmark government bonds from 31 August (before the US bond selloff) to 18 October, 2018 in percentage points. We break down the 10-year yield change to the change in real yields (nominal yields minus inflation) and that in inflation (represented by the yield on the equivalent inflation-linked bond). The breakdown is not shown on 2-year UK and Japan yields due to lack of data.

What is driving the rise in bond yields? We break down the changes in recent months in yields in four key developed economies into their underlying drivers. What we found: Rising real yields (nominal yields minus the rate of inflation, in light blue) have contributed to the bulk of increases in the US and Japan; rising inflation expectations (in dark blue) have been the main driver of yield changes in Germany and the UK. Real yields typically rise on firming growth expectations. To be sure, our BlackRock GPS suggests that consensus estimates for US growth may be too low. The market is adjusting to the Federal Reserve’s recent rhetoric suggesting a potentially higher terminal federal funds rate (the peak Fed rate in this hiking cycle).

Our rate view

The market is pricing in about three Fed rate increases over the next 12 months, in line with our view. Changes in rate expectations are typically reflected in short-term government bond yields. Yet the front end of the US yield curve has already priced in a reasonable amount of Fed tightening. Rising rate expectations are now lifting yields on the long end of the curve as terminal rate assumptions adjust higher. The growing US budget deficit will lead to greater Treasury supply, potentially putting further upward pressure on yields. Even as real yields and the term premium (the compensation for owning longer-dated bonds relative to shorter-dated ones) have risen, investors in longer-dated bonds aren’t yet being adequately compensated, in our view. The 10-year term premium is close to zero or even negative by some measures. We expect a further modest rise in the US 10-year yield toward the top of a 3%-3.5% range – but not much further – over the next six months, as the market weighs Fed actions and the impact of US fiscal stimulus. Yet any growth scares could spark demand for perceived safe havens such as US Treasuries and weigh on yields. 

We still prefer shorter-term sovereign bond exposures globally for now. The relatively flat yield curve in US Treasuries presents an asymmetric risk-and-reward dynamic: Short-term US Treasuries today provide 90% of the yield earned on long-term ones, with far less exposure to the risks associated with holding the latter. They also offer potential price upside if the Fed pauses on its normalisation path. Yield curves in Europe and Japan are somewhat steeper than in the US, yet we still generally prefer the short end because central banks in those countries have yet to start normalising their monetary policies.

Bottom line: We believe it is too soon to add significant exposure to longer-term global government bonds other than in selected areas such as longer-term tax-exempt US municipal bonds. Currency dynamics are making European bonds more appealing for global investors despite their low headline yields. Conversely, higher US yields are largely wiped out by the cost of hedging for euro- or yen-based investors, making domestic fixed income look more attractive. Overall we still see scope for long-term yields to rise in all regions.

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  • Equity markets stabilised after last week’s selloff. Emerging market mutual funds and exchange-traded funds saw the largest weekly inflows since April. Italian government bonds and bank shares sold off on the escalating budget row between Italy and the European Commission. Italian/German bond yield spreads rose to five-year highs.
  • US financial companies mostly reported better-than-expected profits and revenues for the third quarter. Insurance companies posted robust headline earnings, partly coming from a low base a year earlier. Analysts started shaving their forecasts for auto company earnings on escalating trade conflicts.
  • China’s lending and activity data suggested resilient economic growth that may soon benefit from policy support. US job openings hit a record high, reflecting a tightening labour market.

 


 

  Date: Event
Oct 24 Japan Nikkei manufacturing purchasing managers’ index (PMI); eurozone and US composite PMI; Fed beige book
Oct 25 European Central Bank (ECB) monetary policy meeting
Oct 26 US advance third-quarter gross domestic product (GDP), personal income and outlays
Oct 28 Brazil’s presidential election (second round); Germany’s Hesse state holds elections

This week will mark the peak of third-quarter earnings season in the US, with companies representing 36% of the market capitalisation of the S&P 500 Index expected to report. Consumer discretionary, health care, industrials, tech and communications are in the limelight. A large number of European companies are also due to release earnings. Analysts will closely monitor the sturdiness of tech companies’ supply chains amid concerns about trade tensions and the strength of Chinese demand. The rise in the US dollar year to date could pose a risk to the earnings of US exporters.

Managing Director, is Global Chief Investment Strategist for BlackRock
Richard Turnill is Global Chief Investment Strategist for BlackRock. He was previously Chief Investment Strategist for BlackRock’s Fixed Income and active ...

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