State Street SPDR ETFs: Value in allocating to the extremes of the curve
State Street SPDR ETFs: Value in allocating to the extremes of the curve
European central banks believe that they are in a similar position to the Federal Reserve, with rates potentially in need of a tweak higher if inflation does not slow fast enough. Otherwise, rates are likely to remain on hold for some time to come in order to squeeze inflation out of the system.
The potential flaw in this strategy is that growth has already slowed substantially. Eurozone GDP grew only 0.1% in Q2 and the UK rose 0.2%, while composite PMIs suggest the real possibility of a contraction in Q3. With a growth slowdown already in motion, higher oil prices, the policy tightening still to feed through and quantitative tightening ongoing, there are risks of a more protracted growth slowdown.
A growth slowdown in itself may not force central banks into cutting rates immediately if inflation remains stubbornly high, so positioning in short-dated government bonds or investment grade credit also makes sense for European portfolios. However, downside growth risks are significant enough that some protection against a harder landing may be advisable.
In the Q3 Bond Compass, we looked at barbelling risk by allocating both to the front end of the curve and to longer-duration buckets. This strategy had a poor third quarter as the 10Y–30Y spread bear steepened, but it is still an option that could provide portfolios with protection if growth rapidly slows.
Antoine Lesné, Head of SPDR ETF Strategy & Research EMEA:
'Long-end forward rates are now at elevated levels, with the combination of the sell-off and curve steepening pushing long-dated forward rates considerably higher. Most notably, the GBP 15-year forward of the 15-year rate is back at close to 5%, a level that historically it has rarely traded significantly above.
While the EUR forwards do not look quite as extended, the German 15Y15Y is at close to 3%, its highest since early 2014. Historically, high long forward rates should appeal to pension funds as they try to match their long-term liabilities.
Moreover, the summer bond market sell-off has pushed the German 2s10s30s spread below -50 bps, meaning the middle part of the curve now looks richer than in 2008. This suggests that there is greater value in allocating to the extremes of the curve than in the belly.
Some consideration should also be given to how central banks could respond to a slowing economy. Any weakness in labour markets, in particular, is likely to push long-term inflation expectations lower. However, central banks may not want to rush to cut rates as they try to rebuild inflation credibility.
The alternative is to slow the pace of quantitative tightening by reducing the value of bonds that they allow to run off their balance sheets. The improved supply/demand backdrop that should result could be more supportive to the longer part of the curve, which is typically more sensitive to supply pressures.'