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Generosity of central banks set to continue

Central banks are once more providing a bond-friendly environment – but not all investors are equally relieved.

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Editorial

Fixed Income

After our last CIO Day in July, the Brexit shock caused a flight to sovereign bonds, whose yields went on to reach new lows. This was followed by a yield recovery partly fueled by the bold actions taken by the Bank of England (BoE). Other concerns that fell from the radar included China's growth, the Italian banking sector and an immediate rate increase by the U.S. Federal Reserve (Fed). A temporary blip or a trend reversal? The long-term trend definitely suggests that yields were just taking a short breather on their almost 25-year decent. There’s no question yields have seen sharper rises in that period, but until now none of these have been known to signal the onset of a rate-tightening cycle. We doubt we will see the latter any time soon. We believe the European Central Bank (ECB) will decide to extend its quantitative easing until September 2017. The Bank of Japan is also expected to continue its support buying, but in a new guise with the hope of steering both the nominal 10-year yields and the yield curve. The BoE and the Chinese central bank continue to maintain an accommodative mindset despite the BoE's difficulty in cutting interest rates due to inflation worries and China's rate cuts being complicated by exchange-rate targets and over-capacities.

And of course, there is the mightiest central bank, the Fed. Although the FOMC’s decision at its September meeting to hold rates steady was no surprise, what was a surprise was the highly unusual 7-3 vote. This, together with earlier contradictory statements from Fed members, shows the problems U.S. central bankers are having deciphering the anemic recovery. Learning how to deal with lower potential growth and secular stagnation continues to be an adventure shared by both central banks and investors with the difference that central banks are not on a desperate search for returns.

Emerging-market bonds – a sound alternative?


This year, investors could not ignore emerging-market (EM) bonds in their search for returns. Double-digit returns placed emerging-market bonds amongst the best-performing segments of the bond market. There are several reasons we expect their strong run to continue in the coming quarters. For one, we expect the recent recovery in commodity prices to translate into some further stabilization. We also believe that improved balances of payment and lower inflation figures in several of the emerging markets, together with structural reforms and political changes, may provide a positive backdrop. And finally, EM bonds may benefit from a better supply/demand ratio.

Much of this has translated into currency appreciation, creating even more interest in local-currency bonds. Generally, however, hard-currency bonds are still our favorite. Those who prefer to go higher up the risk-return ladder may want to consider high-yield (HY) sovereign bonds. No doubt this segment has the highest risk, but we think a segment that may also be adequately rewarding. In addition, far fewer sovereign bonds run into payment difficulties than corporate bonds with the same credit rating. Still, investors need to select carefully among the more than 40 high-yield issuers because of the diversity of these countries. The U.S. election and a possible hike in interest rates by the Fed in the fourth quarter could cause a setback.

Sovereign yields have recovered from Brexit shock

Investor’s risk-on mode led to some selling during the summer, but we expect sovereign yields to remain low.

Sovereign yields have recovered from Brexit shock

Sources: Bloomberg Finance L.P., Deutsche Asset Management Investment GmbH; as of: 9/26/16.

Corporates still amongst our preferred bonds

While carry is the main attraction for HY bonds, we expect further spread tightening within the investment-grade universe

Corporates still amongst our preferred bonds

Sources: Bloomberg Finance L.P., Deutsche Asset Management Investment GmbH; as of: 9/26/16.

Emerging markets benefit from macro rebound

On a very selective basis, we see good value in EM bonds, as many countries enjoy structural and cyclical recoveries.

Emerging markets benefit from macro rebound

Sources: Bloomberg Finance L.P., Deutsche Asset Management Investment GmbH; as of: 9/26/16.

Forecasts

Little premia left

In an altogether friendly bond environment, our preferences in several segments have changed.

Amid a generally quiet quarter, the Japanese market reminded us how nervous and central-bank-dependent the bond market still is. At the end of July, yields shot higher as the BOJ delivered much of the same and less than hoped. Hard to imagine, but the 10-year Japanese government-bond yields on September 21 returned to positive territory for the first time since April.

While periphery bonds are still our favorites within the European sovereign-bond universe, we see little room for spreads to narrow further. In the high-yield segment, we prefer emerging-market bonds over U.S. corporate bonds. In the investment-grade area, we still favor euro and U.S. corporate bonds.

Fixed income

  Current* Sep 2017F

United States

U.S. Treasuries (2-year)

0.74%

1.15

U.S. Treasuries (10-year)

1.56%

1.80%

U.S. Treasuries (30-year)

2.28%

2.45%

U.S. municipal bonds

94%

93%

U.S. investment-grade corporates

131 bp

115 bp

U.S. high-yield corporates

495 bp

510 bp

Securitized: mortgage-backed securities 2

96 bp

100 bp

Europe

German Bunds (2-year)

-0.70%

-0.50%

German Bunds (10-year)

-0.14%

0.25%

German Bunds (30-year)

0.42%

0.75%

UK Gilts (10-year)

0.67%

1.30%

Euro investment-grade corporates2

125 bp

100 bp

Euro high-yield corporates2

422 bp

420 bp

Securitized: covered bonds

1 bp

10 bp

Italy (10-year)2

135 bp

120 bp

Spain (10-year)2

104 bp

120 bp

Asia-Pacific

Japanese government bonds (2-year)

-0.26%

-0.30%

Japanese government bonds (10-year)

-0.07%

-0.10%

Asia credit

245 bp

250 bp

Global

Emerging-market sovereigns

340 bp

320 bp

Emerging-market credit

366 bp

350 bp

Currencies

U.S.-dollar bull cycle exhaustion

The Fed does not expect any economic variables such as growth, consumer prices or employment to change over the next three years 3. So what is driving the U.S. dollar?Subtitle/Introduction (max. 170 characters)

Investors are getting more evidence that the central-bank policy of expanding the monetary base is reaching its limits. Asset scarcity and the perceived failure of quantitative easing to spur inflation and growth are resulting in a remarkable synchronization of major currencies with real-interest-rate differentials. The euro and the Japanese yen (JPY) are moving in tandem against the U.S. dollar (USD) with their respective differential of nominal bond yields and inflation expectations. This stunningly stable correlation has lasted for a year already and we expected it to persist. Since the Bank of Japan (BOJ) decided to adopt a fixed-yield regime on September 21st, any failure to drive inflation higher should result in JPY stability. The equation is simple: Fix the yields (as the BOJ and the European Central Bank are trying to do), let inflation rise and weaken the currency. The problem is that if inflation remains low or declines, the currency in question may not weaken. Furthermore, other factors such as elections, current-account and balance-of-payment issues, also have an influence on foreign exchange rates. For now, though, it is the real-yield differential that drives major currencies.

EUR/USD and real-rate differentials in sync

Currencies are driven by many factors. Currently they seem closely aligned with real-rate differentials.

EUR/USD and real-rate differentials in sync

Bloomberg Finance L.P., Deutsche Asset Management Investment GmbH; as of 9/21/16

Little conviction

We expect the British pound to further weaken and the U.S.-dollar strength to be less visible.

  Currencies Current* Sep 2017F

EUR vs. USD

1.12

1.08

USD vs. JPY

100

100

EUR vs. GBP

0.861

0.865

GBP vs. USD

1.30

1.25

USD vs. CNY

6.67

6.90

ref-1

* Source: Bloomberg Finance L.P.; as of 9/27/16.

ref-2

F refers to our forecasts as of 9/22/16; bp = basis points.


ref-3

1 Current-coupon spread vs. 7-year U.S. Treasuries.

ref-4

2Spread over German Bunds.

ref-5

3Source: U.S. Federal Reserve, projections from the September 21 meeting.

ref-7

Source: Deutsche Asset Management Investment GmbH; as of 10/7/16.

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