Bond Traders Settle Into Their Happy Place

(Bloomberg Opinion) -- This year hasn’t been kind to bonds. The Bloomberg Barclays U.S. Treasury Index lost 2.14 percent through October, putting it on track for its first losing year since 2013 and the fallout from that year’s “taper tantrum.” That may not sound like much of a loss, but to owners of U.S. government debt, considered the safest investment in the world, anything less than a positive return is a bear market. But there are signs bond traders see better days ahead.

In the wake of the U.S. midterm elections, the Merrill Lynch MOVE Index, which tracks expected volatility in the $15.3 trillion market for Treasuries, had its biggest one-day decline since April 2017. At 53.1, the gauge is back below its average of 52.5 for the past 12 months. That suggests traders don’t foresee any big negative fiscal or monetary surprises that might roil the bond market after Democrats won back control of the House of Representatives. The thinking is that the Democrats will keep Republican spending in check, which might diminish the need for many more interest rate increases by the Federal Reserve. “Democrat control of the House greatly reduces the prospect of additional, large tax cuts over the next two years,” Fitch Ratings said in a report on Thursday. Of course, given Democrats’ reputation of spending freely, such a notion seems far-fetched, but consider that the Republicans had a reputation for fiscal responsibility before enacting a big corporate tax cut that didn’t pay for itself, putting the U.S. on the cusp of a $1 trillion budget deficit and leading to a surge in borrowing. “Markets hope they’ve found the ideal combination of slightly less fiscal easing and slightly less monetary tightening,” Kit Juckes, a global strategist at Societe Generale SA, wrote in note to clients on Thursday.

There’s also the growing belief that the global economy, including that of the U.S., is poised to slow, which should boost the appeal of bonds relative to riskier assets. Moody’s Investors Service issued a report on Thursday saying it expects the pace of global economic growth in 2019 and 2020 to slow to a little under 2.9 percent from an estimated 3.3 percent in 2018 and 2017 amid rising trade tensions. It sees the U.S economy expanding 2.3 percent next year, from 2.9 percent in 2018.

IT’S PREDICTION SEASON FOR STOCKS
The rebound in U.S. stocks from October’s nasty sell-off took a breather on Thursday, as the S&P 500 Index fell as much as 0.67 percent for its first losing day since Friday. Nevertheless, the dour mood is most likely to be short-lived as we’re rapidly approaching the time of year when Wall Street equity strategists offer their (usually) upbeat outlook for the coming year. Currently, aggregate price targets suggest a gain of about 15 percent to 3,169 in the next 12 months. Bloomberg Intelligence is less optimistic. Equity strategists Gina Martin Adams and Peter Chung wrote in a research note on Thursday that their models suggest fair value for the S&P 500 of about 2,975 over the next 12 months. That implies a gain of 6 percent from current levels, “with rising interest rates weighing on valuations and a moderating earnings outlook softening the fundamental view,” the strategists noted. That’s the good news. The bad news is that fair value estimate is down from the 3,090 level they forecast in their update last quarter, the first decline in the assessment since coming up with their models in early 2017. “A high-single-digit gain for the S&P 500 is still likely in the year ahead, based on our macro model, though the downside probability continues to rise as Federal Reserve rate hikes march on and economic momentum slows,” they added. Earnings for the S&P 500 should advance about 10 percent in 2019 toward $171 a share, they concluded.

CHINA FEELS THE HEAT
For the first time in 20 months in October, foreign investors were net sellers of Chinese bonds, trimming at least 9.6 billion yuan ($1.4 billion) according to the China Central Depository & Clearing Co. and Shanghai Clearing House. The consensus was that the decline was due to the diminishing yield premium offered by Chinese bonds. The gap between that nation’s 10-year notes and similar maturity U.S. Treasuries has shrunk to 26 basis points, the narrowest in almost eight years, according to Bloomberg News’s Narae Kim and Carrie Hong. Last year, the spread was 124 basis points. Still, one has to wonder whether the selling also reflects rising concern about China’s economy and the willingness of officials to let the yuan continue to depreciate to offset some of the tariffs imposed by the U.S. The yuan depreciated to 6.9799 per dollar last month, its weakest level since 2008. There are signs that Chinese officials may be getting nervous about being able to control the yuan’s depreciation, which has the potential to spark a flight of capital out of the country’s financial assets. Perhaps the best example of the nervousness is that the nation’s top securities regulator said this month at a meeting with chief economists at Chinese brokerage firms that they should try to guide market expectations and also effectively promote and analyze government policies, according to Bloomberg News’s Tian Chen. China’s October reading of the manufacturing purchasing managers index fell below estimates and new export orders dropped to the lowest level since early 2016.

TIME TO RETHINK AMLO? 
President-elect Andres Manuel Lopez Obrador of Mexico is quickly depleting all the goodwill he built up with investors during his election campaign. You may recall that markets were originally spooked by the rise in the polls of the leftist candidate and his populist rhetoric. AMLO, as he is known, eased those concerns as he and his transition team, consisting mostly of college professors, hopped from interview to interview, stressing central bank independence and budget discipline. But then things started to go off the rails late last month when AMLO ditched a $13 billion airport project for Mexico City backed by some of the nation’s wealthiest businessmen. Then on Wednesday, Mexico’s stock market was one of the weakest in the world, falling 5.81 percent in its biggest decline since 2011 after AMLO’s political party proposed eliminating fees on ATM cash withdrawals and balance requests, as well as commissions charged for printing bank balances and transfers to other banks. Shares of large financial institutions tumbled. “It’s a negative sign for the sector,” Carlos Gonzalez, director of analysis at Grupo Financiero Monex in Mexico City, told Bloomberg News. “A large part of their revenues are from these commissions.” Even the peso fell, weakening as much as 1.39 percent despite some economic data that showed inflation accelerated in October, raising pressure on the central bank to raise interest rates. Higher interest rates are normally bullish for a currency.

GOLDMAN’S MIXED COMMODITY SIGNALS 
Goldman Sachs Group Inc. named only one person within its storied commodities division to its 2018 partner class. Some may take that as a sign that the firm doesn’t see much to get excited about in terms of the commodities market. Perhaps, but it’s interesting that the firm on Thursday issued a bullish report on commodities, saying that raw materials will rebound from their recent sell-off, with a deficit seen in the global oil market this quarter and resilient demand in China for metals, according to Bloomberg News’s Jake Lloyd-Smith. “We remain convinced that commodities will once again rally strongly off this trough,” analysts including Michael Hinds and Jeffrey Currie said in a note received on Thursday. The bank forecasts returns from the S&P GSCI Enhanced Commodity Index of 6.5 percent over the coming 12 months. Commodities tumbled in October along with equity markets, with steep losses in oil and metals. The drivers of the declines were a resurgence of concern in energy markets about excess supply, speculation that global economic growth was slowing amid the U.S.-China trade war and a jump in risk aversion. Goldman’s commodities division has been under scrutiny after suffering in 2017 its worst year ever since becoming a public company, reports Bloomberg News’s Jack Farchy and Catherine Ngai. While the unit has recovered this year, it is still in the spotlight as the company’s revenue from commodities is far below historical levels.

TEA LEAVES
The International Monetary Fund is scheduled to present its Fall 2018 Regional Economic Outlook for Europe on Friday in Copenhagen, and it’s not likely to look very pretty. Euro zone economic data has been consistently coming in below expectations for the last two months, according to Citigroup Inc.’s Economic Surprise Indexes. Moody’s issued a report on Thursday showing that it expects the area’s economic growth to slow to 1.8 percent in 2019 from 1.8 percent in 2018. The IMF is hardly alone in its dour outlook. Even the European Commission is cutting back its forecasts, saying on Thursday that it expects growth to decelerate to 1.9 percent next year from 2.1 percent in 2018. “Uncertainty and risks, both external and internal, are on the rise and start to take a toll on the pace of economic activity,” EU Commission Vice President for the Euro Valdis Dombrovskis said.

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To contact the editor responsible for this story: Daniel Niemi at dniemi1@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Robert Burgess is an editor for Bloomberg Opinion. He is the former global executive editor in charge of financial markets for Bloomberg News. As managing editor, he led the company’s news coverage of credit markets during the global financial crisis.

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