Jim Leaviss, Head of Retail Fixed Interest for M&G’s mutual fund range
With so much talk in recent months around the ‘magic’ 3% threshold for 10-year US Treasury yields, what can we tell about the future direction of markets now that this level has been breached for the first time in more than four years?
First of all, let’s not get too carried away by the recent spike in Treasury yields that has taken the 10-year past 3%. This rise of around 100 basis points (bps) since September 2017 is far smaller than the surge of near 400bps between the middle of 1979-early 1980, or the 200bps surge resulting from 2013’s ‘taper tantrum’, to highlight but two incidences.
What is more significant is the global macroeconomic backdrop against which this has taken place. While there have been a few signs in recent weeks that some of the froth may be coming off the top of growth prospects (some economic surprise indices have moved into negative territory), I don’t see any immediate cause for alarm, and the synchronised global economic growth outlook remains broadly in place. It has been this outlook that has encouraged investors to turn away from the relative safe-haven that government bonds have offered in recent years towards riskier assets.
Given this continued positive economic backdrop, we are likely at a turning point for quantitative easing (QE), while negative interest rates in regions such as Japan, Europe and Switzerland, are likely to be abandoned.
So, after the Fed hiked rates again in March, its sixth such increase since late 2015, can we yet say whether this very protracted cycle is finally approaching a peak? If we look at US unemployment data, around 80% of states now have an unemployment rate below the non-accelerating inflation rate of unemployment (NAIRU). This has historically proven to be an indicator for peaking rates.
As ever, it will likely be inflation expectations that ultimately hold the key. The bond market’s expectations for future consumer prices have risen, with the US TIPS market now pricing in an average of 2% over the next five years. This has risen sharply from last year’s levels, but can hardly be categorised as anything other than ‘moderate’. Furthermore, despite the US being at or near full employment, the link between this and wage growth has remained stubbornly absent. Until wages break out and workers feel the benefits of the global growth boom, then inflation could remain anchored at or close to the Fed’s 2% target. In places like Europe and Japan, despite having implemented ultra-loose monetary policies for years now, central banks are still far away from meeting their inflation targets, with inflation having remained stubbornly low.
It’s worth caveating that economic outlooks can change quickly – as we have seen in the UK in recent weeks. Just two months ago, a May rate hike by the Bank of England was virtually priced in by markets. Last week though, rates were left on hold, with the Bank left trying to retain its hawkish rhetoric by staying upbeat about medium-term growth forecasts, while simultaneously revising its 2018 growth target and short and medium-term inflation targets downwards. Does this mean that we can finally call the end of the 30-year bond bull market? I am still cautious. What is certain is that the unwinding of QE around the globe will leave investors warier of government bonds than before. However, pockets of value remain. Financials, floating rate corporate bonds, and select emerging market currencies (the big EM sell-off year to date has left valuations looking more attractive again) spring to mind.
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