Goodbye Goldilocks

However, selective opportunities remain, including short-duration credit in dollars (across the board) and high yield in euros

What a difference a couple of months can make. Far more quickly than even we anticipated, the dollar has strengthened against the euro, taking it close to our strategic target of 1.15 dollars per euro. By contrast, some of our other calls have worked out less favorably than we would have hoped. We have particularly underestimated the political risks in Italy and their negative consequences for Italian government bonds as well as the intensity of the tariff debate, which has put pressure on emerging markets.

Those events indicate that tail risks are increasing. At the same time, related repricing and volatility create opportunities we aim to exploit. Take the Eurozone periphery as an example: If you look at the yield differential (spread) between Spanish and Italian 10-year sovereign bonds, you can see that bond markets have gotten quite good at differentiating between the various higher yielding Eurozone countries. Since 2013, Spain's economy has grown three times as fast as Italy's. Government finances improved to the extent that we have recently started to treat Spain as a semi-core country and no longer as part of the periphery. The Italy-induced spread widening in Spain makes those bonds highly attractive.

Italy is also worth a closer look. Investors arguably underestimated the difficulties the two eurosceptic parties, Lega and Five Star, encountered in forming a new government. In May, fears of an "Italexit" 1 , perhaps due to deliberate political ploys on the part of Lega, caused a sudden shift in investors' risk appetite. Now that the dust has settled, we remain constructive on the Eurozone periphery. Even Italy is in much better shape than at the height of the Eurozone crisis. Make no mistake, however, the days of simply buying the dips are over. Volatility is increasing and not just in Eurozone sovereign or emerging-market bonds. In the recent Italian saga, the risk aversion rapidly spread to other market segments.

Such episodes are likely to become more common. We appear to have entered the last stretch of the – although extended – business cycle. Central-bank support is beginning to wane. Under the timetable outlined by the ECB, its balance sheet will stop expanding at the end of the year. The first Eurozone rate hike, which we expect in autumn 2019, is likely to increasingly start to drive up yields in anticipation. Yields are already rising as the Fed continues to tighten. That said, don't expect too much, too soon. Over the next twelve months, we expect the U.S. yield curve to flatten further but not to invert. Inflation expectations remain well-anchored. Economic momentum looks solid for now. However, there are plenty of political risks, from trade to renewed Eurozone turmoil. Concerns about hitting a soft patch at some point in coming years should keep a lid on longer-term rates.

Due to the increased attractiveness of the "risk-free" interest rate on short-term Treasuries, we are moving our positioning more towards the short end of the curve. For credit assets denominated in dollars, including emerging markets, we remain cautiously constructive. History suggests that even during periods of yield-curve flattening of the sort we are expecting, credit spreads can remain fairly stable for quite a while. In this respect, we think that the recent spread widening has created selective opportunities in the United States, particularly in shorter-dated corporate credit. In emerging markets, those opportunities particularly exist in some of the riskier sovereigns. We favor hard-currency bonds over local-currency investments. On the corporate side, we view Asian credit as an attractive asset class given the high absolute yield levels.

European credit fundamentals remain solid. We prefer high-yield over investment-grade credit and European over U.S. corporate credit, because it is less exposed to the pace of Fed hikes and to merger-and-acquisition activity. Overall, we are moving back towards less central-bank-distorted, more normal and more volatile credit markets. This brings risks, to be sure. But we believe it is also creating tactical opportunities.

The diverging fortunes of Spain and Italy

Back in 2013, yields on Spanish government bonds were trading well above their Italian counterparts. Since then, we have seen a sharp reversal.

Real federal funds rates remain quite low

By historic standards, the Fed has not tightened monetary policy that much. Real federal funds rates remain exceedingly low. However, this is starting to change.