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

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.

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. 

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.

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:

– Edited by Gayle Bryant