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Bonds And Inflation - The Dynamic Duo To Shake Up Markets In 2018

Published 03/01/2018, 02:38 pm
Updated 06/07/2021, 05:05 pm
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Originally published by AxiTrader

After years of free money and super low rates across the globe, 2018 looms as the year when change is coming to financial markets as central bankers withdraw emergency monetary policy measures put in place to forestall the worst impacts of the GFC.

For nearly a decade now global market's performance has been influenced and driven by the actions of central banks.

Whether it was the banking system, stocks, currencies, sovereign bonds, high yield bonds, or anything else impacted by the printing of money and super low - in some places negative - interest rates, central bankers fingerprints were all over market returns.

It was all done in the hope that animal spirits in the global economy would eventually resurface and growth would return.

But with 2018 looking like a year of synchronised global growth and with central bankers largely satisfied with their efforts on the growth front, the time for emergency measures has passed and stimulus withdrawal has begun.

Currently, markets aren't worried about growth, or central bank actions. Quietened themselves by the lack of inflation in the global economy - and volatility in markets - at present traders and investors are comfortable with a status quo which holds bonds won't sell off too far and rates won't rise too much.

Indeed market pricing in the US doesn't even truly reflect the FOMC's own expected path - as represented by the dot plot - which was articulated at last December's meeting.

It's the very acceptance of this paradigm as 2018 kicks off with more stock market rallies and US dollar weakness, and as bond rates subtly lift higher once again there is a clear risk that inflation once again becomes an issue and or the withdrawal of stimulus puts upward pressure on global longer bond rates.

That's the one overriding theme that I sense is a grey swan hiding in plain sight which could either completely derail markets and their complacency in the year ahead or on the other hand reinforce a continuation of the themes which so dominated 2017 - low volatility, stocks higher, and a weaker US dollar.

CENTRAL BANKERS WON THE WAR TOO WELL

Modern central banking and the fight against inflation, coupled with a rolling series of economic and market crisis has for the best part of 30 years reinforced a global bull market in bonds. But with the success of putting the inflation genie back in the bottle came speculative excesses which flowed from lower interest rates, leverage, a combination which precipitated the global financial crisis.

Indeed, it was a series of crises starting with the 1987 stock market crash and including the Savings and Loan Crisis, LTCM debacle, bursting of the tech bubble, and subprime/housing bust which reinforced this trend toward further rallies and sustained the downtrend.

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Source: St Louis Fed FRED Database

In the most recent case to fight the impact of the collapse of Lehman Brothers and the onset of the GFC central banks went to extraordinary measures which saw official interest and bond rates fall to unprecedented levels.

Central bankers took varying approaches, but the primary consequence of their actions was to drive rates to, or below, the previously sacrosanct zero bound. Associated with this other extraordinary emergency monetary measures such as quantitative easing we also undertaken.

That saw central bankers use their balance sheet in concert with their official interest rates to drive both the front and back of the yield curve lower.

table
Source: OECD Economic Outlook presentation November 2017

Fast forward 9 years from the September 2008 collapse of Lehman Brothers and the US and global economies are on the mend. So it's clear that these unconventional policies have worked. Indeed, all OECD countries are expected to grow in 2018 and the number of countries with manufacturing PMI's under 50 (contraction) has dropped to zero.

That means the time for emergency measures now past.

AN END TO THE GLOBAL BOND MARKET RALLY?

To that end, the US Federal Reserve has been leading the unwind, raising rates gradually over recent years while more recently it has begun what might come to be known in years ahead as the "Great Unwind" where it has begun to reduce the more than $4.5 trillion in assets on its balance sheet. It is doing this by letting bonds mature or coupon payments received flow back to the bank without reinvestment.

And, with the global economy healing there are increasing expectations that the ECB will end its QE program in 2018 and that the BoJ will adjust its purchases in the year ahead as well. Along with the unwind at the Fed together with potential changes in policy at the ECB and BoJ, there are signs the Bank of England and Bank of Canada are likely to continue to raise rates.

This combination is likely to, eventually, put upward pressure on bond rates.

All traders need is a sniff that inflation is heading back toward target, or growth is such that the central bankers are accelerating the withdrawal of monetary accommodation.

Chart
Source: St Louis Fed FRED Database

Of course the idea that rates will sustainably sell-off is an out of consensus call. But with wages gradually rising in the US and the CPI and PPI showing signs of increase back to and through the 2% Fed target the chances that US 10 year bonds break this 30 year downtrend are high.

Naturally at some point that upward pressure then also put pressure on valuations in other markets - including corporate bonds, and stocks?

It has to, almost certainly.

Chart
Source: AFR and TradingEconomics.com

Already in December 2017 US 10 year treasuries traded up to 2.50% and a move toward the 2016/2017 high at 2.65% can't be ruled out if the US economy remains strong, creating more jobs and keeping unemployment low. IF that level breaks then a move toward 2.80% - with a high chance that the 10's trade at and through 3% at some point in 2018 - increases materially.

That's important because with so much money chasing yielding assets, and with spreads so compressed the risk of a bond market induced dislocation across markets more broadly is high if traders and investors even smell the whiff of a return of inflation and central bankers turning more hawkish.

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Source: TopDown Charts Twitter Fedd

Indeed while I’m on valuation metrics the yield on US 2-year Treasuries has, for the first time in a decade, risen to/above the S&P 500 Dividend Yield. Why is that important? It’s important if the stock run starts to stall. And it’s important for cautious investors who are looking for an alternative investment.

Remember, the books for 2017 are closed. Traders need to believe they will see further gains in the markets they trade in order to maintain current asset allocations. If not money will now flow into other markets. So this equivalence between Dividends yield and the yield on Treasuries is important.

Chart
Source: Reuters.com

So should bond markets sell off further it would certainly challenge those who believe low volatility is entrenched in global markets and are happily selling calls on the VIX and other estimates of stock market volatility?

It should also impact on forex markets. But for the moment the fact that the Fed is ahead of its peers in this tightening cycle hasn't helped the US dollar which has struggled since the data started printing weaker than expected in April and since the French election in May.

And it hasn't hurt stocks buoyed by hopes of further growth, tax cuts, a very cautious Fed, and the reality that financial conditions in the US have eased as the Fed has tightened.

Chart
Source: St Louis Fed FRED Database

The counter to all this is that inflation won't come back, that the Phillips curve is a relic of the past, and that the US economy is already moving toward recession - so the flattening yield curve says.

That may be how things play out. But I'm reminded of the most dangerous words in finance when I hear those who say inflation is dead. Those words, This Time It's Different, have brought many unstuck, many times in markets over decades and centuries.

Indeed, for me, the risk is that in a synchronised global growth environment, with oil still rising, and wage pressures emerging, bonds could be the grey swan in plain sight.

Part two - what does it mean for markets - to follow tomorrow

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