We spent a ton of time last week talking about the extent to which the global dovish pivot from central banks along with rampant fears of a slowdown in global growth conspired to catalyze a pretty epic bond rally. The action stateside was exacerbated by convexity flows/hedging dynamics.
You can conjure any number of charts to illustrate the scope and ferocity of the move, which pushed 10-year yields in the US to their lowest levels since late 2017, drove German bund yields below zero lending further credence to the “Japanification” narrative and sent yields in New Zealand and Australia tumbling to record lows.
The ripple effect of the DM bond rally was felt across the fixed income world as market participants grappled with a rather vexing quandary: Dovish central banks and plunging yields on govies “should” encourage risk-taking, but the proximate cause of the dovish turn and concurrent rally in government bonds was an acute growth scare which, if it proves to be more than a “scare”, would eventually be bad for risk assets.
Ultimately, the combination of the dynamics outlined above sent the market value of the world’s IG and HY bonds soaring by more than $1.5 trillion over three weeks:
Meanwhile, the global stock of negative-yielding debt topped $10 trillion again, after falling to less than $6 trillion (less than half of its all-time high) last October.
That’s the context for the latest note by BofAML’s Barnaby Martin, who on Thursday writes that “it’s hard to escape the obvious.”
What’s “the obvious”, you ask? Well, the obvious is that “once again there is a mammoth need for yield across the bond market, as central banks paint themselves into a dovish corner”, Martin muses.
Obviously, this is a bullish technical for credit, especially in the context of the “Japanification” story – deteriorating economic fundamentals notwithstanding.
“If Europe continues to succumb to ‘Japanification’, then demand for yield will simply skyrocket down the line, we feel”, Martin goes on to write, referring readers to the following chart, which shows that if you “simplistically” model global households’ debt holdings based on demographics, you come away thinking that demand for fixed income could top $50 trillion within 30 years.
“Safe to say that this becomes excellent news for credit market technicals, and performance”, Martin flatly states, on the way to marveling that in z-score terms, the plunge in € IG yields has been one the most dramatic on record. He also notes that the the yield on € BBs is now below that on 6-month US bills.
BofAML does suggest that the tightening in euro credit could take a breather given the sheer scope and speed of the move and also considering investors could be lured into US bills to the detriment of demand for euro credit, similar to last year.
But again, this always comes to back to the same question: Which should investors focus on, the dovish pivot and the renewal of the implicit central bank backstop, or the underlying economic picture which prompted that pivot in the first place?
With that in mind, Martin says he hasn’t entirely “forgotten about the data.” To wit:
We keep one eye firmly fixed on it and we believe it remains a risk to the happy consensus across credit markets. Note that global data surprises have been negative for over 250 consecutive days now — a record occurrence.
He also reiterates just how important Germany is when it comes to averting a bloc-wide recession. While BofAML believes the European data “should begin to turn-up as we approach 2H, aided by some stability in the China cycle and Europe’s mini fiscal stimulus”, Martin concedes that “German manufacturing remains conspicuously weak.” He cites a near-record new export order gap with the rest of the euro-area to illustrate.
On Thursday, factory order data out of Germany betrayed a heinous February plunge, underscoring concerns voiced by IWH, DIW, Ifo, IfW and RWI who together now see the German economy growing a mere 0.8% this year, down materially from the groups’ 1.8% forecast in September.
Of course as much as the eurozone depends on Germany, Germany depends on China.
“Given Germany’s importance in the Eurozone supply chain, the longer it takes for Germany to rebound, the greater the possibility that weak manufacturing spills over into other Eurozone countries’ domestic sectors”, Martin goes on to say, before reminding you that “China remains the key to German health, so we believe next week’s China money supply data will give an important read on how effectively China stimulus in playing out.”
Right. And while this week’s PMI data out of China was welcome news, it remains to be seen what the credit impulse will look like going forward now that the January-February holiday effect is behind us and in light of concerns in Beijing that flooding the market with (still more) liquidity could inflate an unwanted equity bubble.
Martin also flags the above-mentioned explosion in the stock of negative-yielding debt and breaks it down by country. Here’s the visual on that:
The “bottom line” for BofAML’s European credit team is that “the bid for quality (read: positive) yield in credit markets will be strong.”
That bid of course pushes those for-now-positive yields even lower, sending everyone even further out the risk curve and down the quality ladder, until everything is priced to perfection.
And the hilarious irony in the whole thing is that the catalyst for it all is a downturn in global growth which, if it were to end up being deeper and more pervasive than anyone expects, would likely be bad news for riskier corners of the credit market and even for some sovereign debt to the extent it’s issued by countries vulnerable to capital flight, downgrades or, just to throw out another example, the dreaded sovereign-bank doom loop.