Duration Carnage
Global fixed income markets experienced a bloodbath last week. Stronger than expected PMIs in both Europe and the United States, combined with oil prices approaching new highs, added further pressure to global rates. Following the sharp flattening move during the first two weeks of September, the long end of the curve sold off aggressively. The latest 5-year US Treasuries auction tailed by 3 basis points, one of the largest tails recorded in recent years. Global appetite for long end bonds remains limited, particularly as competition for duration has increased in recent years. At the same time, governments are becoming increasingly sensitive to higher borrowing costs as debt levels continue to rise, making the market move even more painful. Although part of the recent sell off can be attributed to developments at the front end of the curve, the key question remains whether the Federal Reserve will need to push policy further into restrictive territory, potentially driving short term yields higher, or whether a more modest recalibration of monetary policy will be sufficient to bring inflation back under control. With core PCE inflation tracking above 3% and CPI inflation still above target after several years, the Fed remains in a difficult position.
Growing Concerns
The OAT–Bund spread broke through the 100 basis points threshold last week, reaching levels not seen since 2012. The move reflected renewed concerns over France’s fiscal outlook and the increasingly tense political debate. With the budget deficit expected to remain above 5% of GDP this year and next year, and the debt to GDP projected to continue rising in the coming years, French assets came under renewed pressure. Mélenchon’s strong performance in second round polling remains a key tail risk for markets, given his long standing tendency to downplay fiscal concerns and his aggressive rhetoric regarding French government debt held by the Banque de France. At the same time, Marine Le Pen’s relatively strong prospects of securing a parliamentary majority, combined with the possibility of a tight runoff, have added further uncertainty and pressure. In an environment increasingly hostile to fiscal slippage, France is likely to remain firmly in the spotlight over the coming months.
Algebris Investments’ Global Credit Team
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