The uncertainties that had dogged the outlook for much of 2019 came to a head in Q4, leaving an apparently cleaner slate for 2020. A truce was tentatively agreed to in the US-China trade war, Brexit cleared another hurdle with Boris Johnson’s resounding election victory, and recession risks ─ both in the US and elsewhere ─ appear to have declined.
The principal response across fixed income markets was a fall in precautionary demand for US Treasuries; inflows appear on track to record a six-month low. Treasuries were not abandoned completely though, with much of the selling concentrated at the long end of the curve. Investors are anticipating a continued steepening in the curve in 2020. This is additional proof that recession risks are dissipating, as is the recovery in demand for high-yielding corporate debt in spite of the rash of credit downgrades and the lateness of the credit cycle.
It was not all good news, though, as the elimination of the underweight holdings in Italian and emerging market sovereign bonds was interrupted in Q4. Local currency emerging market debt in particular may have been expected to be the destination of choice for more risk-seeking investors, but the nascent return of inflation and lower real yields are giving investors pause for thought.
The Long Drain on Treasuries
Given the broader background of reduced tail risks, it is not surprising to see precautionary demand for Treasuries weakening over the quarter. Long-term investor demand on a duration-weighted basis fell into the 33rd percentile across the quarter, the weakest reading in six months.
It would be wrong, however, to suggest that investors have abandoned Treasuries altogether. Much of the weakness in demand was at the long end of the curve, with demand for Treasuries with a duration in excess of 10 years slipping into the 13th percentile. Demand for short-dated Treasuries was more or less unchanged and remains robust relative to history. The implication is that investors appear to be anticipating a further steepening in the US yield curve, which is consistent with expectations of steady growth and a lower risk of recession.