Fixed Income Weekly
We view the recent global surge in yields (centering on long-term bonds) as representing an adjustment to reasonable levels following excessive drops in the wake of the Brexit vote. As such, global bond market fears should ease following the upcoming September FOMC meeting and BOJ meeting. Against this backdrop, we suggest expanding duration on KTBs upon yield rises.
Major issues in global bond markets
The global bond market has weakened notably as of late, with softening centering on long-term maturities. Amid the mounting probability of a federal funds (FF) rate hike before year-end, it appears as though the global monetary easing trend has lost some steam, with quantitative easing (QE) efforts by both the European Central Bank (ECB) and the Bank of Japan (BOJ) having reached the limits of their effectiveness. In particular, the BOJ is expected to reduce its QE-related purchasing of long-term bonds – which had been aimed at defending financial institutions’ profitability – and may in turn lead to greater long-short spreads.
But, given lingering deflation fears and uncertainties towards the global economy, it is our view that the global monetary easing trend has not yet reached its endpoint. As such, the recent global trend towards higher yields is unlikely to extend further for two reasons. First, the upcoming September BOJ monetary policy meeting (Sept. 20-21) will likely usher in an additional base rate cut and further QE (to focus on short and midterm bonds). Believing that the BOJ will reduce its purchasing program for long-term bonds, we forecast that a bullish yield curve increasing pressure will be seen in global bond markets. That said, it seems as though predictions for such pressure are already mostly priced into the market. Second, the Fed will likely keep the federal funds (FF) rate frozen at the September Federal Open Market Committee (FOMC) meeting while implying that a hike is in the cards for December. At the same time, however, we expect the Fed to pare back its 2016 GDP growth forecast and its FF rate hike outlook to one hike before end-2016 instead of two, factors which should in turn help ease global bond market fears.
We do not interpret the recent global surge in yields, centered on long-term bonds, as meaning that the global monetary easing trend has run its course. Rather, we view it as representing an adjustment to reasonable yield levels following excessive drops in the wake of the Brexit decision – noting that yields on bonds worldwide have returned to pre-Brexit levels, these yield adjustments appear to have mostly finished. Against this backdrop, we believe that bond yields will stabilize downward after the September FOMC meeting.
Weekly global bond market outlook and trading recommendations
In developed markets, although worries towards a FF rate hike are set to linger, the US bond market should stabilize after the September FOMC meeting. The 10-year TB yield is to move between 1.62 and 1.75 percent, and the 2-10 year spread will likely narrow. The US TB-Bund spread is set to shrink, and the EMU spread should rise slightly.
In Asia, excluding Japan, despite expectations for a FF rate hike by year-end, bond fund inflows into Asian bond markets, although modest, are sustaining. Meanwhile, the Indonesian bond market looks attractive given the possibility that the Bank Indonesia (BI) will announce a base rate cut should the Fed opt to keep the FF rate frozen at the September FOMC meeting.
In the domestic bond market this week, we expect the Korean bond market to strengthen slightly, with the 3-year KTB yield ranging between 1.32 and 1.38 percent, the 5-year KTB yield moving between 1.36 and 1.43 percent, and the 10-year KTB yield fluctuating between 1.53 and 1.61 percent. Despite the recent global phenomenon of rising yield curves, long-term KTBs will likely strengthen vs. their global counterparts thanks to ample demand.
For trading recommendations, we advise, first, remaining long on 10-year KTBs; second, remaining long on 10-year KTBs; third, remaining long on 5-year Indonesian bonds; fourth, maintaining a US 2/10 flattener position; and fifth, remaining long on 5-year Thai bonds.