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Quarterly Outlook: At the crossroads
Simon Fasdal
12 January 2017 at 13:30 GMT
Video / 12 January 2017 at 13:30 GMT

Quarterly Outlook: At the crossroads

Simon Fasdal
Quarterly Outlook
 
  • US 10-year treasury yield likely to break clear of 3% in 2017 
  • Underlying fundamentals and policy shifts are driving yields higher 
  • Expected growth increase will reinstate bottlenecks to US and some of Europe 
  • Negative inflation effect of low oil prices will soon drop out 
  • Overall impact of growth picking up in several regions could be underestimated 
  • Market likely to chase credit premiums as long as global core yields climb 
  • EM seen benefitting from higher investment inflows, more supportive backdrops 
  • Problem for ECB's Draghi is how to exit QE gently and avoid spike in core yields 
  • Our Q1 2017 outlook is available now
By Simon Fasdal

Bonds stand at a crossroads. 2017 will probably be the first year since 2011 (with a small exception in 2013) when we will see 10-year US Treasury yields break 3% on a further upward move.

This projection is based on a change in underlying global fundamentals in late 2016 and shifts in policies from monetary-based quantitative easing (out of ammunition) to emerging fiscal policies initiated by, for instance, the US.

The subsequent impact on global inflation will be substantial as a number of other factors will also come into play:

1. The overall expected growth increase will reinstate bottlenecks for the US and for some European countries, which will lead to a (healthy) pricing power improvement.

2. The negative inflation effect of low oil prices (especially the last drop to $26/barrel) will vanish and be replaced by a neutral to positive impact, with oil rising from present levels around $50/b. Together with other components (including increasing food prices) this will continue to push inflation surprise indices higher, hence lifting US Treasury yields close to 3%.

3. The overall impact of several regions going into a higher growth gear could very well be underestimated, especially the positive effect on emerging-market expectations, stemming from higher growth in developed markets combined with a stronger dollar and commodities.

Highway to hell?

Does this mean that 2017 will be a year to stay away from bonds? Not at all. But the crossroads between chasing duration versus credit premiums will be crucial, and we believe chasing the latter will be preferred as long as global core yields are climbing towards cruise altitude in the vicinity of US 10Y 3%.

Highway to hell
Bonds stand at a crossroads in 2017. Photo: iStock 

Fears of 2013 replays of meltdowns in other bond markets are estimated to have a low probability. The overall positive outlook, also for emerging markets, will create healthy local financial conditions, with EM benefitting from higher investment inflows and more supportive backdrops.

With the European Central Bank likely to pursue quantitative easing for at least the first quarter of 2017, with only a low probability of any tapering comment, the overall combination of European QE and other policy measures (including emerging US fiscal policies) and higher inflation will provide a healthy balance for spread products to perform quite well, despite gradually increasing core yields.

Major risks to this scenario are a significantly stronger US dollar, an inflation shock (highly unlikely) and uncertainty about China’s growth.

Will Draghi do a Houdini?

As US yields have already spiked and are at risk of increasing further, if the positive trends continue in Q1, the big question will be: What will ECB president Mario Draghi do? In the most positive scenario, we could see Europe with a faster-than-expected improvement due to the stronger dollar, improved global growth and expected fiscal policies, which could shift corporate Europe into higher gear. At same time, actual and expected inflation would finally increase, putting Draghi outside the comfort zone of the present QE programme.

The problem is how to exit in a gentle manner? It will be very hard to avoid a swift spike in European core yields, even on the most gradual approach, and, as the distance between QE-world and real-world valuations grows and the gap becomes wider, the impact will be significant. Draghi will use all his skills to achieve a “whatever it takes” gradual pull back, thereby pulling off a sort of ECB Houdini act, which will require a lot of talk and a touch of illusion.

Mario Draghi
Will the ECB's Draghi manage to escape the QE regime in Houdini-like fashion? Photo: iStock 

So we would be cautious on European core yields in the coming quarter and avoid exposure to longer durations in government and other non-spread products. Exposure for Q1 should rather be sought in high-spread products, in corporate US or emerging markets, as well as selected European lower duration, focusing on credit premiums. Positioning should take a multi-asset and diversified approach, and with a focus on hedging abilities.

The later stage of Q1 may well offer new windows of opportunities — the point where entering bond markets full scale becomes highly attractive due to the maturity of the equity rally and hence the opposite ripeness of bond yields.

Simon Fasdal is Saxo Bank's head of fixed income trading.
Quaterly Outlook Q1 2017

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