Bond Mkt May See Return of ‘Policy Mistake Trade,’ BofA Says
(Bloomberg) -- Composition of bond rally has shifted to private investors from official sector, which may reignite the “policy mistake trade” that was “in vogue in 2014,” BofAML strategist Shyam Rajan writes in note.
- Since QE3 ended, long-term rates are down 100bps-150bps across developed mkts
- Further moves from ECB and BOJ into “negative yield territory” may exacerbate shortage of positive-yielding assets; additional Fed hawkishness “increasingly limits” ability of real yields to respond to demand shocks
- Lack of global “relative safe haven assets” has been a “consistent theme” since European crisis in 2011
- Share of AA2 or higher bonds as percentage of BofAML world sovereign bond index has dropped, to ~51% from 84% 2011
- Negative rates have added a “new dimension”
- Private Japanese investors have purchased ~$70b in foreign bonds since BOJ’s adoption of negative rates in late Jan.
- Inflows into intermediate, long-term USTs from European- domiciled funds have increased since 2014
- This may shift the “burden of flows” into USTs, as a number of portfolio managers don’t buy bonds yielding less than their management fee
- Investors in global aggregate indices may be forced into overweight UST positions, given “increasing proportion” of negative-yielding corporate bonds
- Fed is the primary reason why flows that led to lower yields during the last hiking cycle may lead to lower breakevens
- There’s a “shift in perception,” reinforced by a Fed that’s “constantly nudging” the mkt to price in a faster hiking cycle
- A hawkish Fed “relative to market expectations” limits ability of real yields to decline
- Fed’s pace of hiking ~75bps faster than market expectations; projected terminal rate ~125bps higher than market expectations
- Hawkish Fed, plus dovish ECB and BOJ may “embolden” private investors to take unhedged foreign exposure risk, which puts upward pressure on USD
- USD strength weakens inflation expectations, especially when balance sheet constraints hinder ability of private investors to buy foreign bonds on a “fully FX hedged basis”
- Inflation mkts expect major central banks to miss their targets “even over the long run”
- Any decline in response to a global shock is “increasingly shifting to being felt in breakevens”
- Bond “conundrum” similar to last hiking cycle in terms of magnitude and broader context, though “similarities end there”
- Today’s dilemma isn’t about official investors; the focus has been on private investors, particularly Japanese and Europeans
- Related story: Curve Flattening May Reflect Policy Mistake Risk: BofAML
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