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Market questions: how frothy are equities and junk bonds?

Here are the big questions set to frame a new trading week for markets.

How frothy are equity and junk bond valuations looking?
Another record-breaking week for equities and a red hot reception for the Snap initial public offering is not the only sign of investor optimism running wild. Junk bond spreads — the premium investors demand to hold the bonds over Treasury yields — are heading towards post-crisis lows.

The risk premium on high-yield US corporate bonds is now 20 basis points above a low set in June 2014 of 335 basis points. For double-B corporate bonds, the top tier of the junk universe, spreads are just 1 basis point above the post-crisis nadir. While triple-C’s may have further room to run, the surge in high yield debt prices has proven disconcerting to some investors.

Strategists with UBS say that it is becoming “impossible to ignore” the risks, considering US high-yield has priced in “too much good news”.

And looking at equities, the CAPE measure — or cyclically adjusted price-to-earnings ratio — has also risen to a level not seen since the internet boom and suggests a high degree of investor complacency.

Is the US Treasury market breaking down?
Tougher talk from Federal Reserve officials has pushed bond yields sharply higher over the past week. At 2.50 per cent, the benchmark 10-year note yield is above its 50-day moving average and back where it began the year. 

The policy sensitive two-year yield has risen beyond 1.30 per cent, reaching its highest level since 2009 as the bond market has virtually priced in the Fed raising its overnight reference rate in mid-March.

Usually when traders anticipate a Fed tightening, the two-year yield rises at a faster pace than longer-dated maturities like the 10-year note. Instead, we have seen the 10-year yield rise a touch faster, thereby resulting in a modestly steeper yield curve last week.

And investors do have reasons for taking a bearish view on longer dated Treasuries. We are seeing less foreign buying of Treasury debt, led by Japan, and there is the prospect of the US central bank reducing its hefty balance sheet. Then there’s the risk that the US Treasury may sell longer dated paper — perhaps 50-year bonds — as proposed by the current administration to help finance its fiscal expansion.

Will rising inflation change Mario Draghi’s mind on stimulus?
For the first time in four years, annual inflation in the eurozone has breached the European Central Bank’s target, reaching 2 per cent in January on a “headline” basis. 

With unemployment falling and confidence on the rise, policymakers in Germany have repeatedly called time on the ECB’s landmark quantitative easing programme — extraordinary low interest rates and billions of euros of central bank bond-buying have outlived their usefulness, they say. 

Markets are starting to concur: there is a 40 per cent chance of the ECB raising the deposit rate by next April — up from 10 per cent last week — according to Bloomberg data.

So ECB president Mario Draghi will face a conundrum at this week’s meeting of the governing council. 

Cautious policymakers say economic recovery in the region must be sustained before any change in stimulus is considered. Concerns remain about peripheral countries with heavy debt burdens, where inflation has not kept pace with the rest of the eurozone while unemployment remains high. Core inflation in the eurozone — which strips out energy and food prices — remains unchanged at 0.9 per cent.

At the end of last year, the ECB announced that it would extend bond-buying to December 2017 while simultaneously cutting monthly bond purchases from €80bn to €60bn, a QE taper cloaked in an extension. Mr Draghi will be under pressure this week to explain what his institution will do next.

As Brexit beckons at budget time, where next for Britain’s long boom?
The UK government will lay out tax and spending plans on Wednesday, a moment to address questions about the future before it starts the process to leave an economic block which is the country’s largest trading partner. 

The budget comes after a closely watched indicator, the purchasing managers’ index, dropped again in February, sign of economic momentum ebbing. After outperforming the eurozone on this measure almost constantly since the 2011 debt crisis, the UK now lags behind the single currency area. 

Economists at Citi say it is too early to call a downturn, seeing two possible explanations: “With a delay, the EU referendum result is starting to have the originally expected effect,” or two, “the UK has a more mature cycle which is approaching its end and growth would have slowed relative to the Eurozone anyway.”

Either way Philip Hammond, chancellor of the exchequer, has a tough message to deliver.

How much higher can bank bonds climb?
The riskiest types of bank bonds have been in great demand this year. So-called Coco bonds, which convert to equity or are written down in times of distress, have provided investors with returns of 4.4 per cent already in 2017, according to a major index of the securities, also known as AT1 debt.

Yet there have been signs of wobbles in some corners of the market, especially those sensitive to French politics. A $1.5bn capital bond issued by BNP Paribas dropped 2.5 per cent in the first half of February, but has since recovered all of those losses to trade well above its par value.

For now analysts remain enthusiastic for bonds which offer a more attractive income than for much corporate debt. “Despite the fact that political uncertainty has caused some turbulence in bank spreads, particularly those of French banks, we think that the investment thesis still holds and we continue to see sustained interest in bank debt, particularly at the most deeply subordinated part of the capital structure, where AT1 continues to enjoy strong investor support,” wrote analysts at JPMorgan in late February.

Reporting by Michael Mackenzie, Elaine Moore, Thomas Hale, Dan McCrum and Eric Platt

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