Geopolitical, Political Developments to Steal the Reflation’s Limelight

13 April 2017

Relative Value – Sovereign Bonds

Geopolitical, Political Developments to Steal the Reflation’s Limelight

Highlights

¨   Caution Prevails. 10y UST yield are down by 16bps YTD despite a second interest rate hike in a row on March 15^th. The resilience reflects political concerns in Washington, the fully priced in rate hike, a limited inflation outlook and geopolitical tensions (Syria, North Korea). As the economic outlook has not materially changed as acknowledged by FOMC, we foresee uncertainties and risks to anchor UST yields driving a flatter curve. We adopt a neutral view in Europe and Japan as both economies remain highly dependent on monetary policy while technical constraints could limit the scope of intervention.

¨   Geopolitical risks overshadow domestic economy woes. South Korean electorates head to the polls in less than a month on 9^th May to elect another President following Constitutional Court’s affirmative decision on Park’s impeachment. Initial chatters for the new President to deliver a supplementary budget in 2H17 is increasingly being overshadowed by discussions surrounding the rising geopolitical tensions stemming from North Korea. This could place the topic of South Korea’s upcoming supplementary budget into the backburner, subjecting the South Korean economy to be highly susceptible uneven external demand which has failed to lift the manufacturing PMI above 50 over the past 4 months, contrary to trends seen within the AxJ bloc. As such, onus could continue to fall on BoK to keep an accommodative monetary policy over an extended period, which could help to mitigate the climb on KTB yields against the backdrop of rising yield environment.

¨   Rich ACGB valuations likely to stay for some time. 10y AU-US yield differentials have tightened considerably over the past year to c.25bps currently, despite the AUD’s volatility and sensitiveness to global events. While ACGB directionality should continue to track that of global yield movements, we think relative valuations are likely to remain somewhat tight over the near term, given i) subdued global rate backdrop driving yield-hunting capital flows; ii) neutral to cautious RBA; and iii) Australia’s highly-coveted AAA-rating from all 3 major rating agencies alongside its low debt levels. 

Issuer	Yield Curve	Duration	Current Z-spreads
UST	Flatter	Neutral	4.74
Gilts	Neutral	Neutral	-4.52
Core Eur	Neutral	Neutral	-10.97
JGB	Neutral	Underweight	-19.42
ACGB	Neutral	Neutral	-18.00
SGS	Steeper	Neutral	-23.26
KTB	Neutral	Neutral	34.34
CGB	Neutral	Neutral	-110.68
MGS	Neutral	Neutral	3.22
ThaiGB	Steeper	Mild Underweight	9.63
IndoGB	Neutral	Mild Overweight	-72.64
OW/N/UW: Overweight, Neutral, Underweight

	Strategies
UST	·         Tactical flattening 2/10y (Entry: 109bps; Target: 97bps; SL: 115bps; R/R: 2). ·         Strategic tightening Atlantic 10y Spread (Entry 215bps; Target 170bps; SL:  232bps; R/R: 3).
Europe	·         Further widening OAT/Bund spread by 11 to 19bps until French elections are cleared (June 18th) as polls now indicate a possible four-way presidential race. ·         Underweight 10y Greek Bond vs. 10y German with wider spread expected close to its lows ahead of next Greek debt repayment due in July.
JGB	·         Tactical steepening 2/10y (Entry: 25bps; Target: 40bps; SL: 20bps; R/R: 3). ·         Heightening geopolitical risks to limit JGBs downside potential: 30y JGB may have peaked below 0.95%.
UK Gilt	·         Tactical 10/30y steepener offers a duration-adjusted pickup of c.12bps against the curve; 10s30s only c.2bps away from its 7y lows (Targeted Entry: 60bps; Target: 73bps; Stop Loss: 54bps). ·         2y JGBs swapped into GBP for a +58bps pickup vs 2y GILTs.
ACGB	·         Belly of ACGB curve (5-10y tenors) offers a c.2-6bps pickup against the curve and an annualised c.4-12bps roll-down. ·         2y JGBs swapped into AUD for a +70bps pickup vs 2y ACGBs.
SGS	·         2/10y SGS steepener (target entry: 90bps; target: 125bps; stop loss: 80bps). ·         Switch out of 10y SGS into 10y ACGB for a post swap pickup of c.70bps.
KTB	·         3/10y KTB flattener (targeted entry: 55bps; target: 35bps; stop loss: 65bps). ·         Switch out of 3y KTB into 3y CNH CGB for a post swap pickup of c.100bps; major shifts in KRW and CNH likely to be positively correlated, with CGBs’ inclusion in major indices likely to remain supportive towards CNH CGBs.
ThaiGB	·         Long 2y ThaiGB vs 3y KTB, unhedged (target entry: -10bps; target: -40bps; stop loss: 5bps). ·         Tactical 2/10y ThaiGB steepener (target entry: 110bps; interim target: 135bps; stop loss: 95bps).
CGB	·         Long 3y CGB (targeted entry: 3.05%; target: 2.85%; stop loss: 3.20%). ·         Value in barbell strategy, with long positions on 2/3y and 20y CGBs.
CNH	·         Tactical long 10y CNH CGB vs CGB (targeted entry: 120bps; target: 80bps; stop loss: 140bps). ·         Underweight short dated CNH CGBs amid negative carry on a 6m hedged adjusted basis.
MGS	·         3y/5y/7y GII benchmark papers offer an average c.7bps duration-adjusted pickup against benchmark MGS papers. ·         The front-end has cheapened against long-end papers since our Malaysia Annual Outlook report in December 2016. 2019-2020 off-benchmark papers offer a pickup of c.7bps against the curve. ·         For long-term investors looking to extend duration, 2043’s (MGS) and 2035’s (GII) appear to be the most attractive longer-dated papers.
IndoGB	·         We are now more comfortable with extending duration risk within the IndoGB space to play out the Indonesian optimism story, given substantial steepening in the >10y space versus 2016, alongside a possible S&P rating upgrade to IG that may further enhance its investor base towards the more conservative and longer-term managers. We are constructive towards the >20y IndoGBs. ·         2019-2024 IndoGBs offer good tactical opportunities, given non-benchmark papers within the abovementioned tenors offer a c.10bps pickup against the curve, enhanced by the attractive yield differentials versus the BI benchmark rate (4.75%) alongside decent rolldown, with the latter particularly striking in the front-end (c.50bps).

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