Unsurprisingly, the global rates outlook has come to dominate the investment landscape recently.
For all the noise about tariffs, retaliation and trade war, geopolitics is taking a back seat to the more fundamental concern about central bank policy, inflation and long-term interest rates.
This makes sense. As central banks slowly ease away from their super-accommodative stance of the past decade, markets have to come to grips with a whole new landscape.
New, at least from the perspective of the post-crisis experience.
Continued saber-rattling on the trade front will serve to add tension to the situation.
Inflation will rise, not explode
This is the first important realisation for the market to get to grips with.
Normal growth means normal inflation. Very broadly speaking, for the US, a range of 1-3 per cent inflation should not be deemed to be abnormal or risky in a material way.
In fact, for long periods before the crisis, levels closer to 3 per cent or slightly above did not cause huge alarm.
Long-dated bonds can rise too
The experience with bond yields post-2008 is that they were lower, on average, than long periods before the crisis.
If inflation were to normalise, the simple logic is that rates should normalise as well.
It may very well signal the end of a very long bull market in government bonds (US and elsewhere), but that itself is not the same as some calamitous spike in yields that torpedoes the current economic expansion.
The Fed will hike rates in response
As inflation continues on its gradual upward path, the Fed’s excuses for not tightening policy have run out.
The economy is delivering growth, jobs are being added and capacity use is stable at healthy levels.
Our view remains that the Fed will hike rates by 0.25 per cent four times this year.
US Markets – flattening, inverting or what?
A frequent concern raised by bond investors is whether there is a strong chance that the US yield curve is set to invert any time soon.
Presumably, this is another way of asking whether the market is about to discount a recession in the US economy.
This is a valid concern when viewed in the context of the experience of the past five years.
With a few blips in between, the differential between the 10Y Treasury yield and 2Y Treasury yield has been on a downward path since 2013.
Implied further in the question is the view that a curve inversion is followed by an economic recession, almost of necessity, in the same way that the Phillips curve implies that a rise in employment is followed by a bout of inflation.
Whether the empirical evidence supports the contention or not, our view that the 10Y yield will rise to 3.3 per cent over the next 12 months means that an inversion only happens if the short end of the curve moves higher much faster.
For reference, the 2Y treasury was last spotted trading around 2.3 per cent.
Of additional interest are the events unfolding in the Libor market.
Recall that in the time of the financial crisis, one of the canaries in the coal mine was the Libor market.
Interbank funding stress showed up here, and since then, any moves have been scrutinised as a possible signal that some fresh issue is brewing.
Several indicators have been erring on the side of misbehaviour lately.
The obvious one is the Libor rate itself - the 3-month USD Libor rate has risen quite sharply to 2.29 per cent.
In addition, the gap between the Libor rate and the Overnight Indexed Swap (OIS) has been on the rise from November last year, and accelerated its pace of incline in February and March.
So the question is: threat or opportunity?
To answer, it would appear that there are plausible reasons for the moves observed.
First, T-Bill issuance in the US is on the rise, especially recently.
This may be in line with the lifting of the debt ceiling, or the extra funding required after the tax cuts, or a combination of above.
Second, market talk is that some offshore holders who have benefitted from tax relief are large sellers of short-dated USD securities as they repatriate offshore cash.
Finally, the market is quite clearly expecting the Fed to hike at least three times this year and it stands to reason that the Libor market will discount this expectation.
Thus, in the absence of actual signs of systemic distress, this looks like an opportunity for investors who want to reduce duration to shift their exposure shorter into yields that are now more attractive than before.
The European rates picture is driven by some conflicting factors.
We may characterise them as long term and short term factors, for lack of a better way of thinking about them for now.
Longer term, it appears that most economic variables are pointing to higher rates, certainly at the core for Germany and France.
Inflation has been low for very long and this has suppressed rates.
Interest rate volatility in the Euro area has likewise been low, keeping rises in check to some extent.
Core rates may also have been the beneficiary of political risk.
In all these cases, the pressure for lower rates will begin to dissipate.
There has been a recent softening in the PMI numbers. This is in the context of a very solid performance in 2017.
The German composite PMI rose throughout the year to a high of 59 in January this year. A moderation in the pace of increase should not undermine the overall growth momentum.
Likewise, Eurozone unemployment (measured by Eurostat) has declined consistently for the last four years, and the trend is still intact.
Eventually, inflation will begin to creep back into the system.
For the shorter term, there are factors that militate against a sudden rise in Bund yields.
Probably the most important one is the perceived continued dovish stance of the ECB.
Unlike the US Fed, the ECB keeps pointing to the absence of inflation to justify standing pat on rates.
At the same time, it has previously guided that it will begin to tighten monetary conditions for some time to come.
Until it changes this signaling, the market will be slow to discount the coming tightening path.Disclaimer applicable to recommendation
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