Bond yields stuck in a moment
January 5, 2018

Chris Iggo, chief investment officer, fixed Income, AXA Investment Managers, offers his thoughts for the weekend.

Summary – There is no sign of global growth seriously ebbing. Yet bond yields are stuck in a moment. A few more hikes from the Federal Reserve (Fed) and we will have an inverted yield curve. That normally signals recession and a bear market in risk. But what if long-rates are wrongly priced? What if inflation does respond to ever lower unemployment rates? What if the US tax cuts do propel faster GDP (gross domestic product) growth? The data will tell us. Business cycles don't fade and die for no reason. I'm tempted to think this one will be no different. Strong growth, higher inflation, monetary tightening and economic slowdown. It might just take longer. So 2018 is not likely to see recession but it may see more upside to inflation expectations and bond yields.

• Good wishes – First of all let me wish all my readers a Happy New Year. I spent some of my holiday reading Stephen D King's Grave New World and, despite that, I am trying to look forward to 2018 with a sense of optimism. It is true that the world has to an extent retreated from the pursuit of a global model of liberal, democratic market capitalism with populistic nationalism on the rise in many parts of the world. This is manifesting itself in protectionist sentiment, geo-political posturing, anti-immigration policies, a lack of trust in global institutions – both private and public – and a social media-driven dystopic sense of angst seemingly about everything. In the epilogue to his book, Stephen suggests a world where the US has defaulted, the European Union (EU) has collapsed and the global balance of power is an Orwellian-nightmare. Optimism about avoiding a world like that has to be based on the natural desire of society to do better, a realization that globalization has delivered rising living standards across the world and that there are dire risks from allowing a descent into a state of insular nativism. The trend towards taking into account non-financial factors in the allocation of capital (meaning the huge increase in demand for mandates that consider factors like climate change, social justice and equality) suggests that active investors – large and small – can be a force for good in the face of these negative trends. Unfettered global capital flows have proved to be destabilizing in the past, but if they are driven by a desire not just to get a financial return but to improve the stock of human capital, then they can be helpful in reviving a more co-operative approach to meeting common goals of peace and prosperity. I'm also trying to be optimistic about football too, especially in a World Cup year.

• Expanding – Back to the day job. This year is all about making a call on the durability of the business cycle. It is widely acknowledged that the current expansion, taking the US economy as the bellwether, is one of the longest ones in modern times, reaching 107 months in duration. However, globally, the expansion since the Great Financial Crisis has not been without interruption. The European sovereign debt crisis between 2010-2012 was a major setback to global growth, as was the China / emerging market / commodities downturn of 2015. Over the last year, however, the global picture has become much more robust (I know someone who might tweet to claim credit for that!). The developed market and emerging market economies are seeing positive growth across the board and spare capacity is being reduced globally. In the US, the unemployment rate has fallen below the estimated non-accelerating inflation rate of unemployment (NAIRU). In other words, the labour market is officially tight and that has historically always led to a rise in wage growth. This time may be different or delayed, but at some point if the unemployment rate falls towards 4 percent or below, some wage pressures are bound to be seen. German and UK unemployment rates are at cyclical lows, Japan's labour market is tight. (Perhaps we do need robots to do some jobs if there aren't enough actual human workers to do them). The point is the global cycle is running on all cylinders now. The actual growth rate may not be as strong as it was in pre-crisis times (China is not growing at 10 percent-plus growth rates anymore) but there is genuine global economic expansion that is creating jobs and generating significant corporate profits which, in turn, are propelling equity markets to record high price levels.

• Watch what bonds are saying – The normal cyclical pattern is that economies expand, resource utilization increases, inflation starts to rise, monetary policy becomes restrictive and the economy slows down, usually with the cycle ending in negative growth for a period of time. We have global expansion now. As yet, inflation has not risen substantially (hardly at all in fact) and monetary policy is still accommodative. This would suggest the cycle has got much longer to run and would support the continued outperformance of risky assets. However, this is not the message you get from looking at the bond market. Long-term bond yields have hardly budged for the last year and yield curves have been flattening which means that any expectation of a normalization of monetary policy has been concentrated in the front end of the curve. The "new normal" model suggests that the real long-term neutral rate of interest (something that is unobservable, by the way) has been reduced and, in the US, is barely above zero. If that is correct and inflation is going to be close to the Fed's target of 2 percent over the medium term, then a neutral nominal Fed Funds rate would be around 2.5 percent. Today the actual Fed Funds rate is in a range of 1.25 percent - 1.50 percent. Another 3-4 rate hikes and we will be close to neutral, beyond that and monetary policy becomes restrictive. The Fed's median forecasts are for the Fed Funds to reach 3.0 percent in 2020. The current 10-year Treasury bond yield is 2.46 percent and if long rates are supposed to reflect the average of short-term interest rates through the cycle, then that is more or less appropriately priced. Given that the spread between 2-year and 10-year notes has fallen to 50 basis points (bps) in the US, we are within 2-3 hikes of seeing the curve possibly inverted. As noted many times before, that is a key indicator of a recession.

• New normal – So while Donald Trump tweets every new milestone for the Dow Jones Industrial Average, the US bond market – or at least the rates market – is well advanced in pointing to a restrictive monetary policy by this time next year and a recession soon after. This is not a scenario in which long-term bond yields rise which means that bonds can't offer that much of an offset when the inevitable decline in equity prices occurs unless you have a lot of duration and if you are a believer in this "new normal" then you should be adding duration today. There is plenty of academic support for the view that term premiums and long-term neutral rates are lower, largely coming from the Fed's research department itself and finding enthusiasts in those bond market participants that have tended to have a deflationary view of life. At the moment, the evidence is hard to contradict. The Fed has raised rates 5 times yet 10-year yields are barely any higher than where they were at the time of the first hike in December 2015. The implications of this path of events are that we could be in the final stages of the bull market for risky assets and the Fed could be almost at the end of its tightening cycle before the European Central Bank has even started to raise interest rates. The appropriate investment strategy in this scenario would be to reduce exposure to high yield and equities, add duration and be short the US dollar as the US economy heads to recession in 2019.

• Or not – What if the "new normal" is wrong? What if the decline in the term premium was mostly due to quantitative easing and the reversal of central bank balance sheet growth will lead to higher long-term interest rates? What if the US tax reform boosts the supply side, raises productivity and demands a higher real interest rate? What if inflation does rise as global spare capacity is used up? If inflationary expectations rise to, say, 3 percent then the Fed will need to tighten by more than the market is currently anticipating. Break-even inflation rates in the inflation linked bond market in the US have gone above 2.0 percent recently for the first time since Q1 last year. The current state of economic data does not suggest any slowing effect from interest rate moves so far although there will be the usual Q1 seasonal effects on some of the output data (thanks also to the cyclone bomb currently wreaking havoc in the eastern United States). The "new normal" could be wrong simply because everything has been distorted by QE in recent years and once central bank balance sheets start to decline and private sector balance sheets are more healthy, real rates might return to what most people think is trend GDP growth levels (something at least above 0.5 percent).

• Plough on – In a more optimistic scenario of a robust recovery with some upside to inflation and a higher interest rate profile, bond yields would need to move higher to reflect higher inflation and higher real neutral rates. The curve flattening trend would reverse to some extent as longer yields were pushed higher. In credit markets performance has remained well correlated with equities and would continue to do so if growth remains robust. However, at the end of a cycle, credit does start to struggle, especially in the high yield sectors, as higher rates increase refinancing costs and signal a rise in default risk. We are not there yet and the recent wobble in high yield performance last November now seems much more reflective of a few idiosyncratic issuer and sector stories than a systematic deterioration in credit quality. As a side note, high yield has recently seen a resumption of fund inflows after a US$20 billion or so outflow in the whole of 2017. However, spreads across credit sectors are tight and the potential for significant price return is limited going forward. Credit could still outperform government bonds because of the additional carry, but this is slowly diminishing as average coupons continue to decline in investment grade and high yield markets. In the US, tax reform could provide more of a boost to equities than bonds – as appears to be the case – although there is an argument that corporate borrowing will decline thereby raising the scarcity premium in some corporate bond sectors.

• Bonds can eke out returns if inflation stays low, but if not… – Business cycles don't just fade and die. Something needs to happen to slow growth or change investor, corporate or consumer behaviours. At the moment the world is awash with central bank liquidity, interest rates are super-low, fiscal policy has shifted from austerity to being pro-cyclical and asset markets are creating a huge wealth gain. To think that this will all change with another 1 percent on US interest rates is somewhat of a scary thought. There will be softer patches – the usual Q1 seasonal slowdown in the US, the optical softening of growth momentum signals like purchasing manager diffusion indices – but a recession seems some way off. If inflation remains low, bonds will hold their own and credit spreads could narrow further, but overall returns will likely be less than in 2017. If inflation does pick up we may see the long awaited spike higher in yields which could encourage a more positive shift into longer duration assets. For high yield, it is all about equities and corporate health and the bear market there only comes when there are signs that the cycle is coming to an end. The big call is whether that is with Fed Funds at 2.5 percent or higher.





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Chris Iggo, chief investment officer, fixed Income, AXA Investment Managers, offers his thoughts for the weekend.

Summary – There is no sign of global growth seriously ebbing. Yet bond yields are stuck in a moment. A few more hikes from the Federal Reserve (Fed) and we will have an inverted yield curve. That normally signals recession and a bear market in risk. But what if long-rates are wrongly priced? What if inflation does respond to ever lower unemployment rates? What if the US tax cuts do propel faster GDP (gross domestic product) growth? The data will tell us. Business cycles don't fade and die for no reason. I'm tempted to think this one will be no different. Strong growth, higher inflation, monetary tightening and economic slowdown. It might just take longer. So 2018 is not likely to see recession but it may see more upside to inflation expectations and bond yields.

• Good wishes – First of all let me wish all my readers a Happy New Year. I spent some of my holiday reading Stephen D King's Grave New World and, despite that, I am trying to look forward to 2018 with a sense of optimism. It is true that the world has to an extent retreated from the pursuit of a global model of liberal, democratic market capitalism with populistic nationalism on the rise in many parts of the world. This is manifesting itself in protectionist sentiment, geo-political posturing, anti-immigration policies, a lack of trust in global institutions – both private and public – and a social media-driven dystopic sense of angst seemingly about everything. In the epilogue to his book, Stephen suggests a world where the US has defaulted, the European Union (EU) has collapsed and the global balance of power is an Orwellian-nightmare. Optimism about avoiding a world like that has to be based on the natural desire of society to do better, a realization that globalization has delivered rising living standards across the world and that there are dire risks from allowing a descent into a state of insular nativism. The trend towards taking into account non-financial factors in the allocation of capital (meaning the huge increase in demand for mandates that consider factors like climate change, social justice and equality) suggests that active investors – large and small – can be a force for good in the face of these negative trends. Unfettered global capital flows have proved to be destabilizing in the past, but if they are driven by a desire not just to get a financial return but to improve the stock of human capital, then they can be helpful in reviving a more co-operative approach to meeting common goals of peace and prosperity. I'm also trying to be optimistic about football too, especially in a World Cup year.

• Expanding – Back to the day job. This year is all about making a call on the durability of the business cycle. It is widely acknowledged that the current expansion, taking the US economy as the bellwether, is one of the longest ones in modern times, reaching 107 months in duration. However, globally, the expansion since the Great Financial Crisis has not been without interruption. The European sovereign debt crisis between 2010-2012 was a major setback to global growth, as was the China / emerging market / commodities downturn of 2015. Over the last year, however, the global picture has become much more robust (I know someone who might tweet to claim credit for that!). The developed market and emerging market economies are seeing positive growth across the board and spare capacity is being reduced globally. In the US, the unemployment rate has fallen below the estimated non-accelerating inflation rate of unemployment (NAIRU). In other words, the labour market is officially tight and that has historically always led to a rise in wage growth. This time may be different or delayed, but at some point if the unemployment rate falls towards 4 percent or below, some wage pressures are bound to be seen. German and UK unemployment rates are at cyclical lows, Japan's labour market is tight. (Perhaps we do need robots to do some jobs if there aren't enough actual human workers to do them). The point is the global cycle is running on all cylinders now. The actual growth rate may not be as strong as it was in pre-crisis times (China is not growing at 10 percent-plus growth rates anymore) but there is genuine global economic expansion that is creating jobs and generating significant corporate profits which, in turn, are propelling equity markets to record high price levels.

• Watch what bonds are saying – The normal cyclical pattern is that economies expand, resource utilization increases, inflation starts to rise, monetary policy becomes restrictive and the economy slows down, usually with the cycle ending in negative growth for a period of time. We have global expansion now. As yet, inflation has not risen substantially (hardly at all in fact) and monetary policy is still accommodative. This would suggest the cycle has got much longer to run and would support the continued outperformance of risky assets. However, this is not the message you get from looking at the bond market. Long-term bond yields have hardly budged for the last year and yield curves have been flattening which means that any expectation of a normalization of monetary policy has been concentrated in the front end of the curve. The "new normal" model suggests that the real long-term neutral rate of interest (something that is unobservable, by the way) has been reduced and, in the US, is barely above zero. If that is correct and inflation is going to be close to the Fed's target of 2 percent over the medium term, then a neutral nominal Fed Funds rate would be around 2.5 percent. Today the actual Fed Funds rate is in a range of 1.25 percent - 1.50 percent. Another 3-4 rate hikes and we will be close to neutral, beyond that and monetary policy becomes restrictive. The Fed's median forecasts are for the Fed Funds to reach 3.0 percent in 2020. The current 10-year Treasury bond yield is 2.46 percent and if long rates are supposed to reflect the average of short-term interest rates through the cycle, then that is more or less appropriately priced. Given that the spread between 2-year and 10-year notes has fallen to 50 basis points (bps) in the US, we are within 2-3 hikes of seeing the curve possibly inverted. As noted many times before, that is a key indicator of a recession.

• New normal – So while Donald Trump tweets every new milestone for the Dow Jones Industrial Average, the US bond market – or at least the rates market – is well advanced in pointing to a restrictive monetary policy by this time next year and a recession soon after. This is not a scenario in which long-term bond yields rise which means that bonds can't offer that much of an offset when the inevitable decline in equity prices occurs unless you have a lot of duration and if you are a believer in this "new normal" then you should be adding duration today. There is plenty of academic support for the view that term premiums and long-term neutral rates are lower, largely coming from the Fed's research department itself and finding enthusiasts in those bond market participants that have tended to have a deflationary view of life. At the moment, the evidence is hard to contradict. The Fed has raised rates 5 times yet 10-year yields are barely any higher than where they were at the time of the first hike in December 2015. The implications of this path of events are that we could be in the final stages of the bull market for risky assets and the Fed could be almost at the end of its tightening cycle before the European Central Bank has even started to raise interest rates. The appropriate investment strategy in this scenario would be to reduce exposure to high yield and equities, add duration and be short the US dollar as the US economy heads to recession in 2019.

• Or not – What if the "new normal" is wrong? What if the decline in the term premium was mostly due to quantitative easing and the reversal of central bank balance sheet growth will lead to higher long-term interest rates? What if the US tax reform boosts the supply side, raises productivity and demands a higher real interest rate? What if inflation does rise as global spare capacity is used up? If inflationary expectations rise to, say, 3 percent then the Fed will need to tighten by more than the market is currently anticipating. Break-even inflation rates in the inflation linked bond market in the US have gone above 2.0 percent recently for the first time since Q1 last year. The current state of economic data does not suggest any slowing effect from interest rate moves so far although there will be the usual Q1 seasonal effects on some of the output data (thanks also to the cyclone bomb currently wreaking havoc in the eastern United States). The "new normal" could be wrong simply because everything has been distorted by QE in recent years and once central bank balance sheets start to decline and private sector balance sheets are more healthy, real rates might return to what most people think is trend GDP growth levels (something at least above 0.5 percent).

• Plough on – In a more optimistic scenario of a robust recovery with some upside to inflation and a higher interest rate profile, bond yields would need to move higher to reflect higher inflation and higher real neutral rates. The curve flattening trend would reverse to some extent as longer yields were pushed higher. In credit markets performance has remained well correlated with equities and would continue to do so if growth remains robust. However, at the end of a cycle, credit does start to struggle, especially in the high yield sectors, as higher rates increase refinancing costs and signal a rise in default risk. We are not there yet and the recent wobble in high yield performance last November now seems much more reflective of a few idiosyncratic issuer and sector stories than a systematic deterioration in credit quality. As a side note, high yield has recently seen a resumption of fund inflows after a US$20 billion or so outflow in the whole of 2017. However, spreads across credit sectors are tight and the potential for significant price return is limited going forward. Credit could still outperform government bonds because of the additional carry, but this is slowly diminishing as average coupons continue to decline in investment grade and high yield markets. In the US, tax reform could provide more of a boost to equities than bonds – as appears to be the case – although there is an argument that corporate borrowing will decline thereby raising the scarcity premium in some corporate bond sectors.

• Bonds can eke out returns if inflation stays low, but if not… – Business cycles don't just fade and die. Something needs to happen to slow growth or change investor, corporate or consumer behaviours. At the moment the world is awash with central bank liquidity, interest rates are super-low, fiscal policy has shifted from austerity to being pro-cyclical and asset markets are creating a huge wealth gain. To think that this will all change with another 1 percent on US interest rates is somewhat of a scary thought. There will be softer patches – the usual Q1 seasonal slowdown in the US, the optical softening of growth momentum signals like purchasing manager diffusion indices – but a recession seems some way off. If inflation remains low, bonds will hold their own and credit spreads could narrow further, but overall returns will likely be less than in 2017. If inflation does pick up we may see the long awaited spike higher in yields which could encourage a more positive shift into longer duration assets. For high yield, it is all about equities and corporate health and the bear market there only comes when there are signs that the cycle is coming to an end. The big call is whether that is with Fed Funds at 2.5 percent or higher.



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