Global Bond Yields, Bond Sell off and Inflation Break Evens
The size and the severity of the sell-off in US and European rates markets this week, againsta backdrop of increased political uncertainty, does raise the issue of whether the market has overshot and is due for a correction, as the shift in pricing suggests the market is discounting a considerably stronger growth and inflation outlook than it did a week ago.
However, in spite of the sell-off, it is difficult to argue that G4 rates markets are yet cheap. We continue to advocate short duration positions in Bunds, gilts and JGBs, although gilts are very close to the-1.5 cusp at which we switch the signal to neutral because of its low conviction. The UST signal is still neutral, as it is within the-1.5/+1.5 range, but has become more bearish within this range. The main driver of the bearish recommendations remain upside surprises on growth (in Europe and Japan), but momentum has also become more negative across all markets, and positive equity market returns also argue for being short duration. The TIPS breakeven curve bull steepened, driving the expansion in nominal rate term premium. There-pricing makes sense given many of Trump’s proposed policies have the potential to be inflationary and the starting point for TIPS valuations being cheap. With valuations no longer cheap, confirmation of a more inflationary outlook will be needed to sustain the market at current levels.
However, there is a very good reason for valuations and term premia being so extreme at present: fiscal prudence and central bank QE programmes have caused G4 net sovereign bond issuance to be negative in 2015 and 2016,and most likely in 2017 as well. The reduction in duration supply, against a backdrop of increased regulatory pressure on insurers and pension funds to hedge out their duration risk, has meant that bond markets have been abnormally rich for quite a few years yet. Unless there is confirmation that fiscal settings are changing considerably, and/or central banks are winding down QE programmes sooner than markets expect, there is a risk that bond yields can return to trading at very rich levels again.
The most dramatic price action was in theTIPS market, where the 1-week widening in 5y5y break evens was the largest since 2009. Very unusually, the breakeven curve bull steepened, consistent with the nominal price action of term premia expansion bear steepening the curve. Also unusually, the majority of the change in nominal rates was due to the rise in inflation expectations while real yields lagged in the move.
The widening makes sense in that many of President-elect Trump’s policies – fiscal stimulus, a renegotiation of trade agreements, changes to healthcare regulation – have the potential to be inflationary. However, there remains considerable uncertainty about how and if they will be implemented, so it is worth questioning if the market has overshot in pricing inflation expectations so much higher. The starting point for TIPS valuation is that they were unusually cheap, though, so much of the rebound in break evens represents a move back towards fair value. Policy actions, which confirm a more inflationary outlook for the US economy, may be needed to keep break evens at current levels.