Some key levels are definitely in sight for the bond markets. We will have to just wait patiently to see whether yields break out on the upside (which of course means bond prices going lower), or whether abundant liquidity and the ubiquitous search for yield helps save the day. Regular readers will know that we have been warning of the risks of higher yields for some months now. It would appear that we are once again at an important juncture in the bond markets.
Let’s start with Europe, where the ECB is seen as shifting to a slightly more hawkish bias. As can be seen in chart 1, the yield on German bonds has risen in the last few weeks and is testing the highs created last Summer (the dotted horizontal lines). It is worth pointing out that those highs last Summer coincided with a speech delivered by Mario Draghi in which he, for the first time, suggested that not only had deflationary forces disappeared, but inflationary forces may appear in the future.
We think there is a big picture dynamic at work here, which we and others have noted on quite a few occasions. Core European Government bond yields have been forced lower by the combination of both QE and negative interest rates. The European economy is actually doing pretty well at the moment, and with the ECB not only on a path to ending QE (by September under current plans), they seem to be testing the water with slightly more hawkish rhetoric.
There is a bit of cat and mouse going on here. We think the ECB wants to end QE and raise rates, but they will want to do so at a very gradual pace and they will not want to upset the market. So, although we think it is just a matter of time until yields move quite a bit higher, we are very open to the idea that we may see some more sideways type price action before a more sustained move higher (as suggested by the green arrows on the chart). If we are wrong on this point, it will be because yields have moved above resistance and likely moving quite a bit higher immediately.
Chart 1 – German Government Bond Yields (10 and 5 year generic yields)
The first ECB meeting of 2018 will be on the 25th January. We suspect that Draghi will tend towards using language to indicate a more steady as she goes policy progression rather than hawkish language that risks upsetting markets. Draghi is simply not the type to use language that will cause yields to move too far too fast.
In the US, 2 year bond yields have traded above 2% for the first time since 2008. With economic growth at or slightly above potential, and inflation ticking higher towards the Fed’s target, the policy sensitive short end of the market is adjusting as one would expect. Longer dated bond yields, however, are not quite reacting as much as we thought they would. Chart 2 below shows that the 10 year yield is not yet capable of surpassing the last meaningful highs in the 2.60% area, and the trend in the 30 year bond yield is arguably downwards, or flat at best.
Chart 2 – US Government bond yields (10 year and 30 year generic yields)
The next Fed meeting is at the end of January. Not only will they want to avoid upsetting the markets, but a new Chair will be taking over and there are still several appointments that Trump can make if he gets his act together.
So as we sit back and survey the bond market landscape, it appears that we are at an important juncture. Bond yields have been supressed since the GFC, with yields in core Europe being most affected by extremely easy policies. This is like holding a beach ball under water; if you lose control, the ball will immediately rise; and rapidly.
The Fed have been raising rates for some time, and despite personnel changes, we think that the market is used to the gradualist approach. In Europe, the market is not set up for a hawkish tilt from the ECB, and yet that is possibly what may happen. To be clear, it’s not happened yet, but the potential for quite a sharp rise in core European yields is reasonably high at some point in the months ahead.
As bonds effectively set the long term risk free rate, we have to be aware of what impact a rise in yields may have on other markets. Already, the Euro is at a 3 year high against the Dollar, and is only a couple of per cent away from the 2014 highs (prior to Draghi instituting really extreme policies to weaken the Euro) on a trade weighted basis. At some point, there is a risk that Draghi hints of his displeasure at a too strong currency.
For the time being, equities are ripping higher and higher yields are seeming of no concern whatsoever. We covered US equities last week and so we won’t go into detail today. Suffice to say that the momentum in equities is up, and everyone seems comfortable with the old adage that the trend is your friend. For our part, we are resisting the urge to fight the trend, but we remain deeply worried that markets are valued at levels comparable to past bubble peaks, and that when momentum turns, it could get ugly and shake a lot of investors faith. But that is not a story for this week.
So, although many people consider bonds a rather boring corner of global financial markets, they are in fact extremely important, especially as central banks move away from their extreme policies of recent years. Although we don’t expect a move in yields back to pre GFC levels, we do consider yields to be too low everywhere. We cannot discount the possibility that yields will rise by 1% to 2% in some markets in the months ahead, and if this were to occur, then there would be serious losses for bond holders, and probably quite negative implications for other markets.
RMG Wealth Management