December 5, 2019 | By: Andy Kochar, Tom Nakamura, Tristan Sones, and David Stonehouse

A Tale of Two Halves

2.5 min read

High-yield and emerging market debt look attractive to start the year, but don’t count rates out altogether.

 

A combination of macro factors drove a sustained downward shift in yields through much of 2019, leading to an inverted yield curve. As we enter a new decade, however, it appears the ‘heavy lifting’ related to these factors is behind us.

Trade-related pressures within North America and between the U.S. and China, as well as Brexit-related issues in the U.K., may be nearing resolution or a détente for the time being. Combine these abating political concerns with troughing global growth and easier monetary conditions from major central banks, and a reasonable case could be made for a mid-cycle rise in Treasury yields, similar to those experienced in previous cycles. Our belief is that the U.S. 10-year Treasury yield could rise as much as 100 basis points or so from September 2019’s lows to begin the new year, though direction after that becomes less clear.

U.S. Treasuries: Rallying in Waves (1989-2016)
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Source: Bloomberg LP as of July 2019. Yields are represented by the 10-years generic U.S Treasury note.

Repricing in credit markets should be viewed as a buying opportunity for high-yield in this environment of slow positive growth and benign inflation. Some emerging markets have lagged in large part due to trade headwinds, U.S. dollar strength and, more recently, regional weakness in Latin American markets. But a reversal of these factors should be constructive overall despite the need in many developing countries to implement necessary reforms that so far have been difficult to achieve.   

Rate-sensitive bonds, meanwhile, are expected to be negatively impacted by curve steepening in the near term. Among other dynamics, sovereign Canadian bonds could do better than U.S. bonds given the Bank of Canada’s position as the highest-yielding policy rate among developed markets and its discomfort with Canadian dollar strength. While fundamentals suggest moderately higher yields for now, a lack of meaningful inflation globally and lower potential output should limit a more significant rise and the high-water mark that yields reached in late-2018 is unlikely to be tested in 2020.

Much of that, however, will depend on whether central banks are forced to start tightening again in the case of an accelerating cyclical rebound in the economy, or the opposite happens, and they apply further easing due to rising recession fears in 2021.  

If choosing between the two, we believe there is a greater probability that yields resume their downward trend by the second half of 2020. While guidance towards exact timing is fickle, the commonly accepted notion that an inverted yield curve precedes recession has a strong track record in recent history and must be respected. That said, we also acknowledge that the right mix of macro forces could support extended upside in yields beyond the spring, which is something to watch for as the year unfolds.

Andy Kochar is Portfolio Manager and Head of Global Credit, AGF Investments Inc.

Tristan Sones is Vice-President and Portfolio Manager, Co-Head of Fixed Income, AGF Investments Inc.

Tom Nakamura is Vice-President and Portfolio Manager, Currency Strategy and Co-Head of Fixed Income, AGF Investments Inc.

David Stonehouse is Senior Vice-President and North American and Specialty Investments, AGF Investments Inc.

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