The selloff in global bond markets over the past two weeks has investors wondering whether we have reached an inflection point in the extended period of ultra-low interest rates. With the Federal Open Market Committee (FOMC) creeping toward liftoff (still likely in September), eurozone inflation expectations stabilizing and the oil price creeping back up, it is tempting to argue that German 10-year yields near zero and U.S. yields below 2% were, in fact, overly stretched.
However, we remain skeptical of a sustained selloff at the long end of the yield curve. For one, coming out of a weak start to the year for the global economy, G4 monetary policy is poised to remain highly accommodative. Even at the vanguard in the U.S., the preconditions for Fed liftoff have not yet been met, and the FOMC is likely to emphasize that the upcoming pivot in policy will be gradual. Second, the market dynamics behind the recent upward repricing of inflation expectations will be tested as oil prices come under renewed pressure from stretched inventories. Finally, the fact that bond yields in the U.S. and Germany have tended to move in tandem in either direction (over the past month they have each increased by roughly 30 basis points) suggests that easy policy at the European Central Bank (ECB) will continue to weigh on U.S. rates once the current pullback abates.
That said, the selloff in bonds underscores the risk that fixed income markets will retreat hastily when the tide eventually turns. Our read of the moon phases is still at odds with an imminently rising tide, underpinning our modest duration overweight. We also note that at the short end of the yield curve the story is profoundly different. Even a relatively dovish denouement of the FOMC’s liftoff story is consistent with the front end of the yield curve selling off in the coming months, a flatter U.S .curve, and a re-firming of the dollar.
Running of the bond bulls. Bond yields across developed markets have shown a surprising sensitivity to economic data in recent weeks; surprising in the sense that there have not been any unambiguous indications of a broad-based acceleration in growth. Last week was no exception. More evidence emerged of first-quarter weakness in the U.S., and, while global output measures have not been as dour as GDP prints seem to suggest, global manufacturing output slowed in April.
Where the data does, in fact, suggest that the path of rates might be higher is in labor costs and inflation. In the U.S., lower productivity in the first quarter and rising compensation boosted unit labor costs, building on evidence from the Employment Cost Index that wages may be beginning to firm. Eurozone inflation data has also been slightly exceeding expectations, which has fuelled speculation about the expected length and intensity of the ECB’s quantitative easing program.
Signs of incipient inflationary pressure are also on display in market-based measures of inflation compensation. Five-year inflation expectations in five years time (5-year/5- year breakevens), the preferred measure of long-term inflation expectations at the Federal Reserve (Fed) and the ECB, hit 2015 highs last week at 2.25% and 1.82%, respectively.
An integral driver of the rise in inflation expectations is the recovery in oil prices. Brent and West Texas Intermediate (WTI) crude, at about USD 65 and USD 60 per barrel, respectively, are substantially higher than their troughs in January and March, flying in the face of a looming oil inventory glut and U.S. storage capacity reaching stressed levels. Petroleum data last week from the U.S. Energy Information Administration showed the first drawdown of inventories since the beginning of the year; however, the general trends of flat production and highly constrained exports remain intact.
The timing of oil price moves and the repricing of inflation expectations suggest that the two are closely related. The acceleration in crude oil price declines in October 2014 took place in tandem with the sharp drop in 5-year/5-year inflation breakevens. Symmetrically, the rebound in U.S. and eurozone inflation compensation that began at the end of April followed on the coattails of a bounce in WTI and Brent prices. If we are currently at the top end of the range for oil prices in the coming months, as many analysts posit, inflation expectations may well backtrack as this process goes into reverse.
Spillovers and automatic stabilizers. Even though labor market tightness and oil prices are not screaming that inflation will be higher in the near term, we are cognizant of the possible fallout from higher inflation expectations and benchmark rates. Given the low levels they were coming off, the percentage changes in European bond prices have been dramatic. In Spain and Italy, for example, the weekly price declines are on par with or lower than those in the depths of the eurozone sovereign debt crisis. Moves of this magnitude may also give rise to broader spillovers throughout portfolios as negative sentiment spreads to credit or investors cap losses in sovereign debt.
One force for stabilization is the response of monetary policy to higher rates. Were bond yields to continue to rise and begin to feed into tighter financial conditions, the implied path of policy rates in the coming years would implicitly become more shallow. That is, the FOMC would commit to an even more gradual path for the Fed Funds rate and the ECB might extend or even redouble its efforts. Lest we forget, the Fed also has a USD 4 trillion dollar balance sheet that will continue to weigh on long-term rates. An uptick in U.S. oil supply is an additional stabilizer that could emerge from the bounce in crude prices.
In sum, a common thread behind the backup in bond yields appears to be a repricing of inflation. The rebound in crude oil prices, an upswing in inflation compensation, and emerging signs of labor market tightness have sparked concerns that bond yields must rise. While we agree with the general prognosis—that rates are well below where they should be in the medium term—inflation will take some time to normalize from the current exceptionally low levels. That, and a likely dip in oil prices, suggests that bond yields are running ahead of themselves.
Chart of the week
Our Chart of the week shows the ascent of 10-year U.S. Treasury and German Bund yields since the beginning of April. The inflection points for both series towards the end of the month followed turning points in market-based measures of inflation expectations. A continuation of soft economic data or another dip in the oil price may quite possibly temper enthusiasm on inflation, which could moderate or even reverse this process.
Sources: Bloomberg, daily data, as at 7 May 2015
“The dovish FOMC surprise this March is casting a shadow over the Dollar, similar to a year ago. The last time the FOMC damaged conviction, when a “hawkish” dot plot in March 2014 was followed by “dovish” minutes in April. At the time, the Dollar fully unwound what were the makings of a rally and remained in the doldrums until mid-2014.”
“In the aftermath of a dovish Fed surprise, are we cruising for a repeat? We think not. After all, the unemployment rate is a lot lower now and there is a reasonable chance it could approach the Fed’s NAIRU estimate (5.1%) at some point over the summer. Friday’s payrolls report is especially interesting in that regard, because our expectation for solid jobs growth (230k) could come with sizeable back-revisions: on average since 2010, the average 2-month revision in April is 74K, with the smallest being 36K.”
Risk-Reward Into NFP:
“With lift-off approaching and market pricing at the dovish end of the spectrum, we think this is a good time tactically to re-establish Dollar longs. Ahead of Friday, our favorite expression of Dollar strength is versus the Euro and then the Yen.“
EUR/USD, USD/JPY Forecasts:
“We continue to have high conviction in EUR/USD downside (our 12-month forecast remains 0.95) and USD/JPY upside (a 12-month forecast of 130).“
Credit Agricole’s David Keeble said recent CFTC data suggested that there are large levered shorts in 10-year and ultra bonds treasury futures. “We get the impression that most recent price action has been futures-led, because we can see that on the cash curve that most cheapest to deliver securities are at recent extremes of valuations (mostly cheap) to their less liquid peers,” he said. “In the data from the CFTC, levered accounts remain extremely short the 10-year and ultra contracts, but are generally long in the shorter contracts. In other words, they are playing the idea that the Fed will be reluctant to hike rates. While that trade is large, levered accounts have not added to the position last week (to april 28). The bigger selling appears to have hailed from the ‘institutional’ investors in the latest week’s numbers.”
From: Bank for International Settlements (BIS)
A proposed creditor-funded recapitalisation mechanism for too-big-to-fail banks that reach the point of failure ensures that shareholders and uninsured private sector creditors of such banks, rather than taxpayers, bear the cost of resolution.
The template is simple, fully respects the existing creditor hierarchy and can be applied to any failing entity within a banking group. The mechanism partially writes off creditors to recapitalise the bank over a weekend, providing them with immediate certainty on their maximum loss. The bank is subsequently sold in a manner that enables the market to determine the ultimate losses to creditors.
As such, the mechanism can eliminate moral hazard throughout a banking group in a cost-efficient way that also limits the risk to financial stability. The creditor-funded mechanism is contrasted with other recapitalisation approaches, including bail-in and “single point of entry” strategies.