Bond markets on both sides of the Atlantic present distinct economic environments. Central banks are nonetheless optimistic in terms of growth and their wish to normalise monetary policies. Emmanuel Petit reviews the situation.


Emmanuel Petit, what is your analysis of the U.S. bond market?

In the U.S., the adjustment seen since 2017 on short term yields appears to confirm a favourable integration of the Fed’s monetary tightening by the market. The 2-year rate currently stands at 2.85 percent and the Federal Reserve appears to be targeting 3.5 percent by 2020.

The market remains in line with this target for the time being and the Federal Reserve (Fed) seems to be on autopilot to reach it. Conversely, considering the low level of long-term yields, the market does not appear to believe in the sustainability of U.S. growth.

«Considering the inherent situation in Europe, we see an inconsistency on 10-year German yields»

From our point of view, the economic backdrop continues to be favourable despite recent concerns. Moreover, long-term inflation expectations stand at around 2.1 percent, an altogether reasonable level and in line with the Fed’s forecasts around 2 percent. Wage inflation has indeed increased recently, but without risk of overheating.

The Institution is therefore unlikely to tighten its monetary policy too abruptly, favouring, on the contrary, a steady pace to allow growth to maintain its momentum. In our view, a shift in the U.S. Federal Reserve’s stance on this point, in favour of a tougher approach that may disrupt growth, seems unlikely at the moment.

Current monetary policy normalisation, including the Fed’s balance sheet reduction, should therefore see a gradual increase in long-term yields via the resorption of the negative term premium. We thus expect a steepening of the yield curve to levels that are more in line with current U.S. growth. These conditions should help extend the U.S. economic cycle.

What do you think of the European situation?

U.S. rates hikes will, without a doubt, impact the level of European yields. However, considering the inherent situation in Europe, we continue to see a glaring inconsistency on 10-year German yields which remain disconnected from economic fundamentals. The latter have been stable since the beginning of the year, mainly because of the downward pressure from political risk within the EU.

«I believe that Europe is gradually entering the final phase of the credit cycle»

Indeed, the Italian government’s budget factors in an increase of some 0.7 percent in the structural deficit. The European Commission rejected this budget as it stand and has therefore entered into negotiations with the populist coalition. The current period of volatility could extend until an agreement is reached.

This uncertainty, in addition to the forthcoming European elections, has therefore kept the Bund below 0.5 percent but, more importantly, at a real rate around -1 percent, which in no way reflects economic growth in the Eurozone. There is a real probability of normalisation, as soon as political risks will fade.

The decrease in business confidence indices remains consistent with economic growth around 1.5 percent. As recently confirmed by Mario Draghi and Peter Praet, there is a genuine desire within the ECB for normalisation. The Institution keeps sending signals accordingly and very few current factors would encourage it to maintain such an accommodative monetary policy. As a result, we have taken a highly-defensive stance given this interest rate risk with low modified duration.

How has the credit market changed in recent months?

We believe that Europe is gradually entering the final phase of the credit cycle, a stage which has already started in the United States. This phase leads to a tendency to favour shareholder policy at the expense of financial discipline, and shifts companies’ priorities from its creditors to its shareholders. Their gearing therefore increases amid share buyback programs, dividend distributions as well as mergers & acquisitions. This trend usually appears before a cycle downturn.

Companies raise their levels of debt and margins fall. As a result, debt ratios and default rates increase significantly as companies are no longer able to meet the debt obligations to which they are exposed.

«This is an area we are monitoring closely»

We nevertheless remain in the early stages. For the moment, debt ratios are stabilising following a downward trend since 2015, but can we really class this as a downturn? That remains to be seen. What we have for the moment are healthy debt levels but financing via debt is currently more advantageous for companies than recourse to the stock market. The probability of an increase in the level of debt in the long term is therefore high.

This is an area we are monitoring closely. For the time being, we have noted continued significant earnings growth which will keep debt capacity stable. Although there is no risk of solvency deterioration in the short term, changes in these two factors must be monitored over the year ahead.

These elements primarily depend on changes in the cycle and we remain convinced that the latter can be maintained, as well as companies’ ability to absorb debt through increased earnings.
We are nonetheless entering a phase which is harder to manage, during which volatility increases, yields remain at low levels and specific risks are heightened.

What kind of adjustments have you made to R Euro Crédit?

We maintain our highly defensive stance on fixed income due to the risks discussed above. Regarding credit, we also began the year with a cautious approach as spreads were relatively expensive.

«Periods of volatility also allow us to seize opportunities when conditions seem favourable»

We have reinvested the portfolio opportunistically, particularly in September, firstly, as Investment Grade spreads increased by 45 basis points and, additionally, due to good conditions on the primary market with attractive share premia not seen for a long time. Periods of volatility also allow us to seize opportunities when conditions seem favourable.

In terms of sectors, we remain considerably exposed to financials, due to improved sector solvency and strong rates hike potential. This may boost profitability as seen with US banks’ earnings publications following changes in the Fed’s monetary policy. Finally, we remain highly cautious and underweight on the automotive sector which appears to be particularly affected by both the trade war and the accumulation of structural challenges.


Emmanuel Petit is a Managing Director & the Head of Fixed Income at Rothschild Asset Management Europe.