Article / 03 October 2016 at 10:00 GMT

Quarterly Outlook: Carry me home

Head of Fixed Income Trading / Saxo Bank


  • Bonds have enjoyed strong year so far on back of QE, low-inflation environment
  • Core yields continue to remain low as global inflation lags
  • Inflation taking hold could put core European bonds in the firing line
  • An end to QE, oil spike would impact core bonds
  • Emerging-markets bonds rally can continue into Q4 despite risks
  • The carry trade looks set to run the duration of 2016

By Simon Fasdal

All bond classes have performed admirably so far in 2016. Quantitative easing and low inflation have been the driving forces, but also at play was a revaluation of the refashioned emerging market bonds which – as we had predicted – outperformed in the third quarter.


Source: Bloomberg

We also foresaw quite an upbeat scenario following Brexit and a dilution of fear stemming from overexposed risk factors like Chinese growth, low-priced oil and general EM worries. What we did not foresee is the still elusive global inflation and a rather sluggish growth pattern.

This resulted in core yields remaining low for most of Q3 with no outlook to a higher path anytime soon.

Does this mean that we have an even bigger bond bubble ready to burst in Q4? Not really. In fact, one of the major issues is the lack of global inflation, which is not only dragged down by lower commodity prices but also by an overall lag of global growth.

Admittedly, the engine is running, and some regions are seeing higher growth levels, but the overall sentiment is that global growth surprises to the downside.

The Growth Surprise Index


Source: UBS, Bloomberg

This is not necessarily bad for bonds, because it prevents – or at least delays – central banks turning from dovish to hawkish, starting with the Fed. It also keeps the QE doors open in one form or another for the European Central Bank and the Bank of Japan.

So as long as we have a status quo on growth and inflation, there exists a very fertile environment for spread over products, and this explains why we have seen some of the riskier bond classes perform well in Q3.

The big question, of course, is where we should focus our attention in Q4.f

The Brexit vote was not a bad thing for bonds at all. Photo: iStock

Core bonds

We’re still very cautious on most core bond markets, especially European government bonds in longer maturities, and related products. The risk of being hit by the first wave of inflationary fears would be felt most strongly here.

The risk of this is slight, but imagine a sudden and sharp increase in the price of oil propelling inflation expectations. In turn, this could spur the hawkish camp of Fed members into action and force ECB chief Mario Draghi to pull the carpet from under QE letting the “whatever it takes” determination disappear into thin air.

And should we see a substantial spike in oil not only would core bonds feel the impact, a wave of turbulence would hit all financial markets too.

Despite the fact that events are unlikely to pan out like this, the sensitivity of financial markets to one single commodity is huge and worrying, and is certainly something to keep in mind.


Source: Bloomberg, Saxo Bank

European corporate bonds

As virtually everyone has now lost faith in European corporate bonds, we think it’s time to question if this really is a “no-go” area of the bond market.
Due to ECB QE and overall demand for higher rated bonds, most of the investment-grade bonds offer little or no value. With some parts of the segment carrying negative yields we do not see much value at all here unless you, as investor, are obliged to hold a considerable stake in it.

The European high yield segment is also affected by the contraction of European fixed income, but we have not seen the same contraction as in investment grade, and we believe that the current credit spreads justify (i) the overall low yield environment and (ii) the gradual improvement in European sentiment. That said, a major risk for the European credit market remains – the banking sector troubles that could spill over into other areas.

However, for corporates and sectors that will benefit from the overall stimulus in Europe, low oil, the weaker euro, QE and a gradual improvement of European sentiment, as well as the chances of looser fiscal policy, the present level still offers some value.

The iTraxx Xover


Source: Bloomberg

Emerging market bonds

EM bonds have seen a tremendous rally throughout 2016, even though some market participants warned against the segment as far back as the New Year. The overall rally stemmed from a combination of stabilising EM forex, the overall low inflation sentiment globally, a hesitant Fed and accommodative policies from the ECB and the BoJ along with dovish statements after the equity selloff early in the year.

One can argue that emerging markets are at risk of a setback if we see a trend towards higher global inflation, hence higher global yields. Should we see a big shift in sentiment all bond classes would be at risk, including emerging markets, but our observations show that EM could trade more robustly than other bond classes in a higher inflation scenario.

The reasons for this are:

     (i) Increasing global yields would be a sign of health for the world economy that would imply 
         opportunities for most emerging markets.

     (ii) The rally of 2016 has been more a question of catching up with other bond classes, as
          shown by the overall cheapness of EM compared to other bond classes (political and
          structural risk factors factored in).

     (iii) The correlation patterns we expect do not indicate that EM would be the most vulnerable
          class in the event of sudden spikes in global yields. Instead, it would be core bonds that
          would take the first hit as we expect an improved outlook for the global economy would
          have a positive impact on overall credit risk premiums.

Emerging markets looking strong in 2016


Source: Bloomberg

Even in a worst-case scenario with spikes in global core yields, we do not envisage a huge global selloff in riskier bond classes. Again, moderations in maturities must be taken into account.

If we continue the present trend of gentle upturns in global growth, continued sluggish inflation and some turbulence in a sideways equity market, then every oasis of yield will continue to be a haven for global investors, who in our view will continue to upscale allocations in markets that can still yield something.

This would support emerging market bonds in the process. The carry trade is here to stay in 2016.


Emerging-market bonds have enjoyed a big rally in 2016. Photo: iStock

— Edited by Clare MacCarthy

Simon Fasdal is Saxo Bank's head of fixed income trading.


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