Update Bonds: Are we getting used to risks?
US ten-year Treasury yields continued to fall and stayed below 4% for most of this week. European yields followed, with ten-year Bund yields staying below 2.6%.
Risk premiums started to recover from a modest jump last week when the US-China trade war flared up. The impact of such events seems to become less severe and more short-lived as we move through this extremely turbulent year. Are investors getting used to these risks and ignoring them more and more?
Downside risks are now clearly less than they seemed to be in the first half of this year and may increasingly be balanced by more positive risk scenarios. The US economy remains more resilient than expected, and some worst-case scenarios that seemed likely earlier in the year, such as the escalation of tariff wars or the conflict in the Middle East, are now less likely.
Meanwhile, the US central bank is becoming more dovish, which is sooner than we had anticipated and under increasing pressure from the Trump administration. As such, investors could be tempted to add more risk to their portfolios under these circumstances.
Despite the fog of the ongoing government shutdown in the US, the global macroeconomic situation seems to have further improved. However, the US economy was still sending mixed signals of strong economic growth but a stagnating labour market until the government shutdown interrupted the flow of most economic data. Only inflation data will be published on Friday.
In this environment, emerging markets have been doing remarkably well. Fiscal consolidation, stronger external balances and proactive monetary policies have already improved the credit quality and ratings of emerging-markets sovereigns. And more Fed cuts and dollar weakness will further reduce the burden of their external debt. On top of this, emerging-markets economies are expected to grow faster than developed-markets economies. This is a key tailwind for emerging-markets bonds that could benefit from a stronger risk appetite among investors.
While central banks are expected to keep rates lower than usual over the next few years, especially in the US, increasing worries about long-term inflation and government debt sustainability will probably require an increasing risk premium for longer term bonds. Investors should be aware of these risks when looking to add credit risk to their portfolios. Strategies that play the steepening of the yield curve could perhaps provide some nice diversification.
