Article / 21 December 2016 at 11:35 GMT

Weekly Bond Update: Return of the yield curve — #SaxoStrats

Head of Fixed Income / Saxo Bank
Denmark
  • There has been a very rapid move in 10-year US Treasury yields
  • But there are indications a global selloff in other bond markets can be avoided
  • The strengthening global economy and US dollar are two factors

By Simon Fasdal

There are undoubtedly positive signals when looking at the global economy here on the verge of 2017. We ended the year on higher highs in equity markets with some regions starting to surprise on global growth.

On a global scale, as well, inflation is beginning to move – both on surprise indices and in inflation figures. 

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A little rough: There may be some turbulence next year but opportunities are 
emerging for investors to diversify into bonds. Photo: iStock

All of this is good news for the world economy, as removing the deflation ghost once and for all has been a key strategy for central banks for a long time. But it's not all "happy days"...

We have also witnessed a very rapid move in 10-year US Treasury yields, similar to the situation after former Federal Reserve chair Ben Bernanke's famous "tapering" comment in May 2013 – this time surging more than 1% from the summer low around the 1.50% area.

Last time, with help from Bernanke, the spike in US yields sparked a global selloff in bond markets, sending corporate bonds and emerging markets into meltdown mode as US 10-years hit 3%. Will it be different this time around?

Well, if we see more proof for global growth and inflation, global core yields could go higher, but there are factors that indicate we might not see a global selloff in other bond markets this time around:

The global economy is improving

An improving global economy is not only helpful for Europe and US – all countries should benefit, including emerging markets. "Old" BRIC countries like Brazil and Russia have been struggling with low and even negative growth due to very low commodity prices and an overall standstill in the global economy. 

They among others will benefit from foreign demand, for example for iron ore, as well as a higher oil price.

The stronger dollar

The recent strengthening in the dollar is extremely helpful for exports to US markets, something that on a broad basis brings activity back to both Europe and emerging markets. As long as EM currencies are not "falling out of the bed", then the stronger dollar helps to support local financial markets.

No signs of market disturbances

In the 2013 selloff, a lot of the fear was related to a lack of liquidity, hence major US bond-holders sold out of EM assets as they were afraid of the lack of liquidity in the markets, leading to a self-fulfilling prophecy. 

Market conditions have not improved regarding liquidity, but it seems, at least for now, that there is a broad-based bond shortage related to corporate bonds and emerging market bonds as new investor segments enter the bond market. The central banks' QE programs are also having an effect.

European bond markets remain under heavy QE influence

The European Central Bank buying of both government and corporate debt has pushed down European yields and offset the normal correlation between US and European government bonds for now. This makes bonds from other markets more attractive, thereby increasing allocations into these markets as we enter 2017.

Return of the yield curve

As global yields move higher, the attractiveness of bond markets return, as yields will start to reflect a more attractive level for investors. Expected inflation is also taken into consideration. Furthermore and most importantly, investors with a bond portfolio will once again have the opportunity to "ride the yield curve",  a strategy that has been absent due to the very flat yield curves globally. 

So all in all, there is positive news, even for bond markets, if global inflation and growth starts to rise. We could face some turbulence next year, but with increasing yields and maybe further spikes in equity markets, opportunities could be emerging for investors to diversify out of equities into bonds. 

We will keep our eyes open for these windows of opportunities as we enter 2017.

'A spinnaker catching the winds':  US Treasuries yield curves have already moved...
US treasuries yield curve
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Source: Saxo Bank

– Edited by Gayle Bryant

Simon Fasdal is Saxo Bank's head of fixed income trading.

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