How fundamental differentiation is key as ECB starts buying bonds

US powering towards full employment 

The latest non-farm payrolls report showed an increase of 295K jobs despite weather related issues in February. In terms of the longer-term trend, the 12-month average job increase is now running at 275K per month compared to the 200K average recorded at the start of 2014. Added to this is the fact that the unemployment rate metric dropped to 5.5%, bringing it into the natural rate territory (around 5% to 5.5% based on Fed’s assessment). In addition, broad indicators of US labour market also continue to show a very healthy picture with the Kansas City Fed labour market conditions index displaying signs of increased momentum in recent months.

Indeed, the run of strong labour market data has now tipped the scales firmly in favour of a June hike with strong evidence supporting the view that the US economy is fast approaching full-employment despite a largely subdued inflation picture. The debate on the Federal Reserve front has been two-sided lately, mainly on the back of cautiousness emanating from international dynamics, where we have seen a number of central banks led by the ECB initiate another round of global monetary easing.

However, with economic decoupling between the US and the rest of the world in full-swing currently, the monetary policy profiles are also diverging and this contrast is only likely to become stronger as we approach Q2.

European data shows improvement but QE to remain with us for the “foreseeable future” 

Recent high frequency data in the Eurozone has been surprising to the upside. For instance, Citi’s Eurozone Economic Surprise Index has increased from -57 in October 2014 to +49 currently, with bulk of the increase taking place in February. The positive reading on the surprise index implies that data in the single currency union is beating expectations, while readings in the absolute sense, although still weak in level terms, seem to be generating positive momentum.

Give the above backdrop of improvement in short-term economic momentum, it was interesting to see Mr. Draghi pin the upside revisions to growth and inflation forecasts on pursuing the QE programme to its logical end (i.e. at least September 2016). This kind of front-loaded conditionality differs from the Fed, which predicated the size of its third programme on the pace of incoming data. Indeed, Mr. Draghi’s remarks confirm that their QE programme is likely to remain with us for the foreseeable future and that improved high frequency data is unlikely to shake their resolve, given structural headwinds still facing the economy.

Economic decoupling further strengthening rates decoupling 

The sharp economic decoupling seen in recent quarters has certainly also manifested itself in market pricing with the yawning interest spread between Europe and the US a good example of this dynamic. However, February’s fixed income market gyrations showed that volatility and curve dynamics are also becoming localised with economic fundamentals creating a much deeper influence on markets.

For instance, during the month of February, 10yr bund yields traded in a 8 bps high-to-low range, while the corresponding range in US 10yr yields was more than six times larger at more than 49 bps as the stronger-than-expected January payrolls release re-introduced hiking expectations. Similarly, in terms of curve shape, the US 5/10 slope remained roughly unchanged over the month (despite considerable intra-month volatility), while the European curve steepened.

All in all, our analysis suggests that fundamental differentiation and its influence is deepening further with strong evidence of localised volatility and future rate expectation dynamics taking hold in fixed income markets.

Fundamentals remain key as liquidity risks rise further

In our research, we have often raised the point that central bank policies continue to dominate investing decisions by keeping low rates low in a bid to support aggregate demand. However, it is becoming clearer by the day that an important unintended consequence of the ultra-easy monetary policy is the rising liquidity risk in bond markets (see Strategy Insight “Quantifying Bond Market Complacency” June 2014). With the size of corporate debt markets rising 42% since the crisis to USD 7.7 trillion, exacerbated by diminishing inventory (due to tighter regulations), risks of a liquidity-induced shock have certainly increased. However, given the over-arching differentiation focused environment, we think fundamentals will be important in identifying the winners from the losers and the current dismal bond market liquidity environment increases the importance of adopting a fundamentals-focused approach to fixed income investing.