Fundamentals

The global re-opening narrative continues to gather pace, and progress on additional fiscal stimulus in the US serves as a further boost to the pro-growth outlook. The sanguine reaction of central banks added fuel to the fire in the last week of February, as they acknowledged that the move higher in rates was due to improving growth but did little to push back. There are three scenarios we believe could spur central banks to take action. First, if the move higher in real yields were to tighten financial conditions and negatively impact risk markets. While there were hints of this dynamic on certain trading days in February, the moves were not sustained and ultimately risk assets seem to be focused on the constructive growth picture. Second, if the front-end of curves begin to rise, thereby challenging central bank forward rate guidance (conversely, we expect central banks will continue to be relatively comfortable with higher long-end yields). And finally, if market conditions were to deteriorate and become disorderly. Given that the latter two of these scenarios happened to varying degrees at the end of last month, we are keeping a keen eye on the reaction of central banks in the coming weeks. 

Quantitative valuations

February 2021 was the worst month in modern times for government bonds, with a return of -2.13% at the index level. Certain markets experienced particularly extreme moves: 10-year yields were 79 basis points (bps) higher in Australia, 49 bps higher in the UK and 46 bps higher in Canada. This noteworthy move in rates had a negative impact on the total return of more duration sensitive markets, such as investment grade credit, which was down more than 1% on the month. However, spreads across fixed income sectors were relatively well contained: high yield and investment grade credit spreads actually tightened in February, by 27 bps and 6 bps respectively, while emerging market hard currency sovereign spreads widened by a marginal 7 bps. While there is now less scope for spreads to tighten meaningfully, we believe that valuations reflect the strong fundamental outlook appropriately. (All data to 28 February 2021).

Certain government bond markets experienced extreme moves in February

Source: Bloomberg; data as of 28 February 2021.

Technicals

Low liquidity exacerbated the rise in government bond yields in the last week of February, with the expansion of bond market intermediation failing to keep pace with bond market growth. This dynamic will be important to watch as low liquidity raises the potential for future bouts of volatility. Consensus positioning is another point to monitor, as investors generally still hold a short rates bias. Nevertheless, the ongoing easy monetary policy environment and the resulting search for yield continues to be the overarching technical underpinning bond markets, which we expect to persist.