Monetary policy makers walking on eggshells. Economic data continue to support the global-recovery-less-inflation story. This complicates further the action of central banks which have started to embark in a tightening cycle in the wake of the Federal Reserve. Softness in DM inflation is unlikely to be only transitory

4 August 2017

Relative Value – Sovereign Bonds

AxJ Central Banks Not Onboard the Hawkish Train Yet

Highlights

¨   Monetary policy makers walking on eggshells. Economic data continue to support the global-recovery-less-inflation story. This complicates further the action of central banks which have started to embark in a tightening cycle in the wake of the Federal Reserve. Softness in DM inflation is unlikely to be only transitory (cf. “The USD consolidation, Donald Trump Self-fulfilling prophecy”, 29^th June 2017) and markets barely believe now in a third US rate hike in 2017 while the Fed enters unchartered policy territory to reduce its balance sheet.  Meanwhile, the ECB finds itself now in a similar situation than the Fed faced four years ago when the bank tapered its QE which led to a sharp USD rally. An even stronger EUR might not be desired by EU policymakers which could refrain them to actively support a tightening rhetoric. Setting up policy in Japan appears somewhat more straightforward with a near zero-inflation constraining the bank to its QQE.

¨   Wide SGS-UST spreads to remain supported over the coming months. SGS-UST spreads remained wide on the back of ample domestic liquidity, with the 2y and 10y spreads lingering near its 2-year high of 20bps and 25bps respectively. The moderate improvement in domestic loan activity with an YTD expansion of 5.6% y-o-y (5m16: -1.1%), exerted pressure on SGS, spurring a brief period of tightening SGS-UST spreads. Against the backdrop of a low base, we expect domestic loan activity to continue improving, albeit at a modest pace and unlikely to trend higher towards double digit y-o-y growth rates, limited by the modest pace of GDP expansion alongside the low likelihood for any easing property measures. As such, we maintain our view SGS to continue trading at 15-20bps premium vs UST of a similar maturity, suggesting value in keeping an overweight stance on UST vs SGS.

¨   MGS: Spooked by EM sentiment again? Despite the asset’s lacklustre performance in 2016, MGS has not seen a substantial “catch up” relative to peers. This was despite a more subdued global rates backdrop, robust economic indicators and relatively stable government ahead of a potential General Election. 10y MGS yields fell c.25bps since BNM further enhanced its FX rules in April, but the rally has since stalled amid rising EM and global liquidity concerns. Given the above alongside reasonable inflation levels, BNM is likely to stay benign over the coming months, keeping MGS yield movements restrained compared to previous bouts of volatility; we think a neutral duration strategy remains appropriate given little positive catalysts amid lingering uncertainties creating fat tail risks. 

Issuer	Yield Curve	Duration	Current Z-spreads
UST	Flatter	Neutral	5.38
Gilts	Neutral	Neutral	-5.58
Core Eur	Neutral	Neutral	-26.84
JGB	Neutral	Underweight	-18.18
ACGB	Neutral	Neutral	-10.29
SGS	Steeper	Neutral	-7.99
KTB	Neutral	Neutral	31.57
CGB	Neutral	Neutral	-28.94
MGS	Neutral	Neutral	-4.41
ThaiGB	Steeper	Mild Underweight	9.15
IndoGB	Neutral	Mild Overweight	3.74
OW/N/UW: Overweight, Neutral, Underweight

	Strategies
UST	·         Tactical flattening 2/10y reached previous target; keeps further potential (Entry: 90bps; Target: 65bps; SL: 100bps; R/R: 2.5). ·         Close the tightening Atlantic 10y Spread recommendation at c.170bps.
Europe	·         Benchmark 10y German Bund offers a c.20bps pick up against the curve; wait to upgrade the Bund view to mild overweight until 0.50% is penetrated. ·         Long 3y KTB vs 2y Bund (target entry: 245bps; target: 190bps; stop loss: 265bps).
JGB	·         Stopped out on our steepening 2/10y; shift to neutral curve view. ·         Super long-end bonds (>20y) relatively attractive versus the belly.
UK Gilt	·         5/20 GILT flattener for an estimated c.22bps pick-up against the curve (Target Entry: 118.5bps; Interim Target: 106bps; Target: 95bps; Stop Loss: 125bps). ·         Long 2y Gilt versus Bunds (Target Entry: 94bps; Target: 75bps; Stop Loss: 104bps).
ACGB	·         Long 5y ACGBs versus USTs on an unhedged basis (Target Entry: 45bps; Target: 20bps; Stop Loss: 60bps). ·         5y JGBs swapped into AUD for a +89bps pickup versus 5y ACGBs.
SGS	·         Maintain overweight stance on 10y UST vs 10y SGS. ·         Switch out of 10y SGS into 10y ACGB for a post swap pickup of c.70bps.
KTB	·         Buy 10y KTBs on a 3s10s30s fly (target entry: 45bps; target: 10bps; stop loss: 60bps). ·         Long 3y KTB vs 2y Bund (target entry: 245bps; target: 190bps; stop loss: 265bps).
ThaiGB	·         Long 2y ThaiGB vs 2y Bund, unhedged (target entry: 220bps; target: 175bps; stop loss: 240bps). ·         Tactical 2/10y ThaiGB steepener (target entry: 100bps; interim target: 135bps; stop loss: 85bps).
CGB	·         Overweight short dated onshore CGBs over its offshore counterpart with a similar maturity; tight onshore-offshore spreads provide little incentives favouring the offshore CGBs given poor liquidity. ·         Swap 10y KTB to 10y CGB for a post swap pick up of 125bps, unhedged.
CNH	·         Overweight short dated onshore CGBs over its offshore counterpart with a similar maturity; tight onshore-offshore spreads provide little incentives favouring the offshore CGBs given poor liquidity. ·         Keep an underweight view on short dated CNH CGBs, given unattractive carry on a 6-month hedged basis alongside weak liquidity.
MGS	·         10y benchmark GII paper offers a pickup of c.12bps (c.18bps duration-adjusted) against 10y benchmark MGSs, and should benefit from an eventual catch-up in foreign GII holdings and mean-reversion movements. ·         Maintain a mild flattening bias on 3/10y (Target Entry: 59bps; Target: 39bps; Stop Loss: 70bps). ·         For long-term investors looking to extend duration, 2043’s (MGS) and 2047’s (GII) appear to be the most attractive longer-dated papers.
IndoGB	·         We turn neutral on super long IndoGB papers; the strategy netted small gains overall since our last RV update. ·         2019-2025 IndoGBs continue to offer good tactical long opportunities (c.6-12bps pickup against the curve), enhanced by the attractive yield differentials versus the BI benchmark rate (4.75%).

This message is intended only for the use of the person(s) to whom it is addressed and may contain information that is privileged or otherwise protected from disclosure. If you are not the intended recipient you are hereby notified that any use, review, disclosure or copying of this message and the information it contains is prohibited. If you receive the message in error, please notify the sender by reply e-mail and discard all its contents.   Thank You.