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Kay Van-Petersen
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Article / 03 January 2018 at 11:00 GMT

Weekly Bond Update: January may be chilly for bonds – #SaxoStrats

Head of Fixed Income / Saxo Bank
Denmark
  • There are some indications that changes will occur in the low-yield environment
  • While these changes are never certain there are some factors to consider
  • These factors include rising inflation and commodity prices

By Simon Fasdal

Happy New Year and welcome back.

In Scandinavia, January is normally a month to avoid and to stay indoors, with freezing temperatures, chilly winds and abundant rain or snow. This year the same could become true for core bonds, that is, to avoid and let go, as we have seen a couple of indications late in 2017 that we're now starting to play a more upbeat tune of potential changes in the year-long low yield environment. 

However, a big change is not certain and looking back over the past eight years, predicting rising yields and being short the bond market has generally become known as widow makers. Therefore I am still hesitant to put all my eggs in the short basket, but I think the following factors are worth having in mind as we enter the rainy headwind of January.

Inflation on the rise

Although inflation is still at quite low levels, there is good evidence that global inflation is on the rise. It is still difficult to see a clear trend change in the US and Europe, but Japan, for instance, is now starting to see decent inflation numbers (1% in December vs. 0.6% expected), and this is not only related to the recent higher energy prices. 

Despite a year-long lack of inflationary pressure, US and European sentiment has started to change, as it is clear that some countries and work sectors now lack employees, which by now has already started to build the first signs of bottlenecks and pricing pressures. 

Higher commodity prices add pressure

The big falls in oil prices in 2015 and 2016 had a huge effect on inflationary pressures and were the catalyst for the low yield and low inflationary scenario for a couple of years. Remember we more or less ended a five-year period of oil prices spiking around $100 with falls towards $25, a fourth of the price compared with the previous 1-5 years. This was a huge game changer for bond markets, which extended the rally for an additional two years.  

Now oil prices are creeping up above $60, and despite our own belief that the major resistance may be a bit higher, the present oil price, together with higher overall commodity prices, provides additional upward pressure on inflation and yields.

Effects of QE tapering

We have already seen some of the global quantitative easing being extracted from the market but with very little impact so far. European yields in particular continue to be very low, which in many ways is due to the continued bond buying from the European Central Bank. 

One thing to be aware of is the direct impact following the first signs of real tapering from the ECB. But another more unknown tail risk is the fact that many bond owners are "lazy" in the sense that many institutional carry trades are established, and not really touched upon before a whole new investment environment occurs. 

So an imminent fear of higher yields is simply not enough to scare anyone to exit these trades. Despite the very poor risk/reward, the lack of better alternatives make investors hold on to these, which could lead to swift moves later on, when the obvious choice for everyone being to get out. The ECB has many decisions to make in the coming months.

As already mentioned, crying wolf over higher yields has been analysts' approach for almost a decade and for a reason. There are still factors that can play in and bring the rising yield to a halt. Some of the things to watch include:

  • Developments in Asia, as one-third of expected global growth will come from China and the whole region is now crucial to the global economy. 
  • Technological developments can halt the expected inflationary track, as automation and technology will remove pricing pressures in certain sectors when jobs are being replaced with robots. This is something that will kick in medium-term.
  • A short-term factor is the stronger EUR, as this may hinder the ECB from taking any near-time decisions on tapering and remove any hawkish stance, hence, the rising yields might be brought to a standstill.

Nyhavn
January temperatures make it easy to avoid going outside but
should we also be avoiding core bonds. Photo: Shutterstock

– Edited by Gayle Bryant

Simon Fasdal is head of fixed income strategy at Saxo Bank.

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