Brexit and Trump have been kind to the fixed income traders of the world. After long years when banks questioned whether their fixed income trading divisions had fallen into a morass of secular stagnation and were worth maintaining, they’re suddenly back on top. Fixed income traders are out-gunning investment bankers, and this is likely to continue.
For anyone wondering exactly what 2017 will hold for fixed income trading professionals, Deutsche Bank’s industrious fixed income strategists released (another) huge report on the prospects for credit markets in 2017 earlier this week. At 60 pages, it’s not short. It confirms that if you work on a fixed income, you are living through “interesting times”. Here’s our (greatly summarized) version of its contents.
1. Things are about to get very exciting again
2017 will be a “transitional year,” say Deutsche Bank’s strategists. Debt is high across the globe, but the U.S. government (and to some extent the UK government) are set to relax fiscal policy and increase spending. Policies are likely to diverge globally. Deutsche says the U.S. is likely to “implement serious fiscal stimulus but without Fed QE supporting it, whereas Europe will have no meaningful fiscal stimulus but lots of QE.”
“The days of one-way dovish monetary policy, with no fiscal spending and low volatility in asset prices and growth are likely over,” says Deutsche. With change, comes opportunity.
2. But things cannot be normal without catastrophic change
As fixed income traders work to make the most of divergent government policies, Deutsche notes that they’ll be labouring under a cloud: “The global financial system remains broken and extremely fragile….The world has too big a debt burden for the current growth environment. We would feel far more comfortable if the world went through a huge creative destruction period where zombie, inefficient debt was allowed to default – thus ‘right-sizing’ the ratio between debt and GDP.”
Unfortunately, Deutsche’s strategists say this much-needed purge would likely create a huge negative feedback loop and depression. For this reason, they say it’s, “highly unlikely to happen outside of perhaps a future break-up of the Euro.”
3. Trump could be the catalyst for this catastrophic normalization
The question fixed income traders will be grappling with next year (and maybe in 2018 too) is whether the populist surge that allowed the election of Donald Trump as president of the U.S. is repeated in elections across Europe. If so, this could be the catalyst for the eurozone’s collapse.
There are elections in France, Germany, the Netherlands, and possibly even the UK next year. All will be watched closely by fixed income desks. The excitement will start with the Italian referendum on December 4th.
4. Spreads and volatility will rise
As uncertainty returns to the market, spreads (the difference in yields between treasury bonds and all other bonds are likely to rise). Overall, Deutsche is predicting a year of “mild spread widening” as fiscal policy expansion makes a comeback (Figure 1).
At the same time, they’re expecting volatility to return to its long term average after a period in which it’s been unnaturally subdued (Figure 6).
Both are good news for banks’ fixed income desks. As the charts below show, peaks in volatility typically lead to peaks in banks’ fixed income trading revenues. Unfortunately, fixed income trading headcount is on a long term downward trend as trading is automated, but a revenue increase may at least stem further headcount cuts.
5. Central bankers are losing control
After years in which central bankers ruled the markets, Deutsche’s strategists think they’re now losing control. The world’s central banks have so many spinning plates they can’t keep them all up. Worse, the frantic spinning is creating problems of its own.
“The faster the plates are spun the more the unintended short-term consequences,” says Deutsche. The main problem is that the European and Japanese banking sectors have been squeezed by negative rates and flatter yield curves. This has made it harder for banks to lend money, thereby perpetuating low economic growth.
2017 will therefore see fixed income traders watching both for the political events that signal a more expansionary fiscal policy and for any tapering of existing low interest rates and Quantitative Easing (QE). The European Central Bank in particular will be watched closely: although the ECB will struggle to taper “in numerical terms” next year, Deutsche predicts it will change the rules to allow it to buy shorter dated securities, thereby reducing the average duration of its portfolio.
The Bank of England will continue with its corporate bond buying programme in 2017 (it targeted £10bn of investment grade bonds over 18 months, starting last September), which should be good for debt capital markets bankers working on DCM issuance. The ECB is also expected to continue with bond-buying through its Corporate Sector Purchase Programme (CSPP), even though this is due to be subsumed by broader quantitative easing from March 2017.
6. Yield curves will steepen
With years of ultra low interest rates and QE slowly coming to an end, Deutsche is predicting steepening yield curves as the long term risk of holding bonds increases. Steepening yield curves are almost always good for banks’ revenues. Steepening may not last, however: Deutsche foresees a risk of “much flatter curves” if the Federal Reserve signals rate hikes in the short term, but also has to compete with the Bank of Japan and the European Central Bank who are artificially suppressing yields on their 10 year bonds.
7. Beware the first quarter
Remember the first quarter of 2016? Banks’ fixed income trading revenues plummeted as clients pared their trading activity amidst worries about emerging markets.
Deutsche is warning that something similar could happen in the first quarter of 2017 – and again during interludes throughout the year. Markets are likely to get spooked by, “President-Elect Trump’s spending plans and worse still the anti-establishment fervor may have a greater chance of spreading through Europe now.” Deutsche says there could be “extreme” moves in bond spreads as a result. This could be bad if volumes fall, for good for trades who are on the right side of the changes.
8. Fixed income traders will need to become avid politics watchers in 2017
Central banks will remain active in 2017, but Deutsche says they will cede control of markets to politicians. The big questions fixed income desks will be asking in 2017 are: “How much fiscal stimulus will the US manage to push through under Donald Trump? Will Italian PM Renzi lose the referendum at the end of 2016 and will there be general elections in 2017 in a country where the anti-establishment party 5SM could win power and even call for an EU referendum? Elsewhere will the anti-establishment movement in Europe be boosted by Donald Trump’s victory and Brexit, and will elections in Austria (December 2016), France, Holland and Germany throw up further problems for the EU?”
Fixed income traders may want to read up on European politics during their seasonal breaks.
9. On balance, this should be good for trading desks at banks
As years of low rates come to an end, Deutsche is predicting an end to the “financial repression and flat curves” which, “created an ever more challenging operating environment for banks, with mounting pressure on their margins.”
Thanks to Trump, Deutsche says trading desks may also find themselves less fettered by high compliance costs and pressures to build capital and cut risk taking.
2017 could be the most exciting year on fixed income desks for a long while.