All change for the markets, or maybe not
Our base case for rates markets is a gradual shift higher, but there are reasons to consider why even our forecast is too constructive and the move higher could be more substantial.
1. A change in the Fed’s interpretation of its inflation mandate. We have blogged on this before, but the chatter from senior Fed officials is becoming too loud to ignore. Moving to a targeted inflation range of 1.5% to 2.5%, or having an average target of 2% across a 5 year period, would be interpreted as the Fed being more inflation tolerant at the current moment, and would, in our view, result in a steepening of the yield curve and higher longer dated yields.
2. Significant increase in supply of Treasuries in 2018. Forecasts for 2018 vary, but even the most conservative has supply in excess of double that of 2017, and that’s without the Fed expanding its balance sheet this year. Todays $15bn 30 year auction will be an interesting test for the market.
3. Only the very front end of the Treasury curve is aligned with economic forecasts and the Fed’s dot plots. The 2 to 5 year part of the curve needs to steepen.
4. The US inflation data undershot expectations on 5 occasions last year, starting with the March data released in April, meaning when these soft comps drop out this year the series is more likely to surprise to the upside.
5. Absolutely no hint of recession anywhere. Prior to the, much spoken about, globally coordinated recovery, there seemed to be a recession just around the corner somewhere in the world. This helped to keep an anchor on long dated bonds, as the instrument of choice to protect portfolios, while the awaited recession became reality. This anchor has gone now, and economic forecasts are the most bullish since the GFC.
6. Lastly, and far from least, the most overvalued bond market is German Bunds. Draghi’s elusive inflation target is almost perpetually untouchable, according to Bund yields. This week’s settlement by Germany’s most powerful union, IG Metal, is a stark reminder that wage inflation is on the way, even in Germany. German unions are amongst the most pragmatic, seeking to protect jobs during recession, rather than grab inflation busting pay deals. But now, with Germany enjoying record low unemployment and roaring business sentiment, it’s payback time for the Unions. IG secured a 2 year deal worth close to 4% per annum. Other unions will be following IG’s lead.
Despite the move upwards in government bond yields so far this year, and their lure as a risk off asset, we think it’s prudent to keep exposures to the short end of the curves, to avoid mark to market losses while the yield curves adjust to the new environment. The big theme for markets in 2018 is undoubtedly “reflation”.