Weekly Bond Update: Fear factor higher than yields — #SaxoStrats
- Much talk at the moment of an imminent rise in yields
- Despite upbeat macroeconomic developments, inflation has not materialised
- Central banks have expressed concern about bond levels being overstretched
- But the trigger – expected increase in inflation – may be a long time coming
has yet to materialise. Photo: Shutterstock
The recent debate in fixed-income markets can be described as a re-run of a reoccurring subject: when do yields take off? We have seen several articles and research pieces lately describing the expected imminent rise in yields and ideas for investors to cope with the upcoming dramatic change.
There are indeed indicators that things are turning better in the global economy: the European economy is improving, recent numbers from the US have surprised to the upside, and the fear of a Chinese setback (that we highlighted lately) have not materialised yet, rather the opposite.
Source: Bloomberg/Saxo Bank
The improvement in the global outlook and the lack of huge geopolitical risk triggers have left their mark on financial markets. Most major equity indices are at record highs; credit spreads are closing in on pre-crisis levels, and emerging market bonds are setting new highs on a weekly basis. So it's happy days for risky assets.
It seems that not only riskier bond classes, but also developments in the global stock markets are the gifts that keep on giving. When markets break one record, they just aim for the next.
And this awakens worries from the past. These are the levels seen before the crisis. So is it happening over again? Are we on the brink?
It is fully justifiable to be worried, but it is worth identifying why we are at the present levels, and also examine why it has been so hard for global yields to move higher.
Despite upbeat macroeconomic developments, inflation has had a very hard time materialising. We firmly believed earlier this year that we would see higher yields caused by inflationary pressures, but the reality has been different.
Even in economies where unemployment is low and the economy is heating up, it is very hard to see real inflationary pressure, although it is expected to come. Maybe it is delayed, or maybe because our inflation expectations will have to be reconsidered.
Maybe we are ahead of the curve, but one might argue that going forward, everything that can create bottlenecks – whether it is related to employment or a shortage of commodities – can either be technologically innovated into a scalable version or technologically globalised, so that the risk of bottlenecks becomes extremely low. So future expectations of inflation should also be lower.
If this is correct, yields will have a hard time taking off any time soon, hence, effectively cancelling out any spread-related selloffs in riskier bond classes, high-yield or emerging markets. This also justifies the low market volatility, indicating concerns are at a very low level, with nothing much to worry about.
We could face other volatility triggers as investors tend to exit markets that have seen massive rallies, and some EM markets could be affected by political/geopolitical risk, as well as swings in the US dollar.
But the overall concern of a bond-bubble explosion caused by higher benchmark yields? This is something we have a hard time seeing materialise any time soon.
But what about the central banks? Central banks have expressed concerns about levels being overstretched in stocks and bonds. This will eventually lead to the beginning of the end for quantitative easing in Europe. We could see also fixed-income investors worry about the US Federal Reserve's reduction of its balance sheet. (See also Christopher Dembik's discussion of ECB president Mario Draghi's "impossible task" here on TradingFloor.)
But the overall trigger point for central banks is the expected increase in inflation, something that could be a long time coming.
Will yields finally rise? Yields fixed due to QE? Or do investors know that inflation is related to the oil spike more than anything else?
Source: Bloomberg/Saxo Bank
A good example is the recent spike in inflation in Europe, which produced hope for a sustainable and healthy inflation at "old" levels. The problem is that the spike is mostly related to the recent recovery in oil prices. A recovery that stalled at $50/barrel, and with little faith that we will see further gains.
In fact, the problem is deeper because domestically generated inflation (DGI) in the euro area shows sign of resilience towards external shocks, and even more worryingly, seems to weaken. In that context, it is not obvious that we will see the European Central Bank change anything anytime soon, as the fear of triggering a lower euro area growth path will overshadow the fear of asset bubbles.
A final reason why gravity is so hard on global yields is the inertia from huge investment funds that have long strategic positions in fixed income. As long as yields are unchanged and volatility is low, they will keep anything that looks like a carry trade and will exit later rather than sooner, as year-long attempts to go short bond markets and betting on the bond-bubble explosion have been named "the widow maker".
So to sum up:
- Investors should be vigilant in all markets with mature rallies – the same goes for stocks and bonds.
- Present levels can be seen as overstretched. But, if the new inflationary paradigm is true, benchmark yields will stay low and riskier bond classes will continue to converge at lower yields, exploiting remaining risk premiums, and even stock markets could be set for additional rallies.