Tuesday, October 27, 2020

BlackRock Upgrades German Government Debt As European Economy Slows

 From the BlackRock Investment Institute, October 26:

Chart of the week
U.S. 10-year nominal and real yields, breakeven inflation rate, 2017-2020

U.S. 10-year nominal and real yields, breakeven inflation rate, 2017-2020


Sources: BlackRock Investment Institute and Refinitiv Datastream, data as of Oct.12, 2020. Notes: U.S. 10-year nominal yield refers to the 10-year Treasury yield. Real yield refers to the yield of 10-year Treasury Inflation-Protected Securities (TIPS). Breakeven inflation rate refers to the difference between the yields of a nominal bond and an inflation-linked bond of the same maturity – the 10-year maturity in this case.

Developed market (DM) government bond yields collapsed after the Covid shock and since appear to have found a bottom. The economic restart has been quicker than expected, even though the hardest part of the recovery lies ahead. Significant fiscal stimulus under a united Democratic government – an election scenario that markets are increasingly pricing in – could put upward pressure on Treasury yields. Yet the rise in yields would likely be limited as the Fed would act to prevent a sharp tightening in financial conditions, in our view. We already expected rising inflation over the next few years, as production costs rise and the Fed has pledged to allow inflation overshoots and let the labor market run hot. The monetary-fiscal policy revolution may also place greater political constraints on the Fed’s ability to lean against inflation. We see the prospects of a unified Democratic government accelerating the market pricing of these dynamics. Breakeven inflation rates, a market-based measure of expected inflation, have rallied since March. See the green line in the chart. We see inflation-adjusted, or real yields, falling further, supporting prices of Treasury Inflation-Protected Securities (TIPS).

We are upgrading German government bonds (bunds) to neutral, reflecting our greater caution on Europe’s economic prospects. As Covid infections have picked up , the focus on further policy response has shifted to more monetary easing including additional asset purchases. Our views on bunds or U.S. Treasuries shouldn’t be considered in isolation. We believe nominal DM government bond prices are headed lower, and expect bunds to have more modest price declines than U.S. Treasuries. Bunds are also likely to be less volatile, in our view, thanks to large-scale ECB asset purchases that have driven net issuance into negative territory, as well as the potential for further monetary policy support.

These latest changes in our tactical views align with our strategic views. We favor reduced exposure to nominal DM government bonds and greater allocations to inflation-linked bonds over a longer horizon, as interest rates remain near  their lower bounds and inflation risks grow. We don’t expect nominal bond yields to rise as much as the inflation backdrop might typically imply, as central banks keep rates low and allow temporary overshoots of their inflation targets. This environment could persist for some time, providing a favorable backdrop for risk assets....