Market sentiment at the beginning of 2018 can best be characterised as increased confidence in the global growth outlook, that inflation will follow, and central banks will continue to withdraw their support of markets and normalise monetary conditions. We agree.
In the United States 10-year Treasury yields have broken out of their recent range and are testing the highs in yields we saw at the start of 2017. Of course, last year yields then drifted lower as inflation went through a mid-year soft patch. In our view, higher US bond yields this year are supported by the fundamentals. This view is supported by the US 2-year Treasury yield last week moving above 2.0% for the first time since the GFC in late 2008.
1) Higher growth = higher inflation
Growth recovered nicely in 2017 after a lacklustre year in 2016. We expect it to move higher again in 2018 as the tax reform package impacts on activity. This means growth will be above trend, the unemployment rate should move lower again and we will see upward pressure on wages and inflation. At least that’s how it’s meant to go. In a repeat of last year, market based inflation expectations are back up to 2%. All we need now is for the inflation data to support that! We are off to a good start with December CPI data out at the weekend showing a stronger than expected increase in core inflation and the rolling three-month annualised core CPI at 2.5%.
2) Monetary policy tightening
Monetary policy is set to be tightened further in 2018, with the US Federal Reserve (the Fed) indicating it is likely to hike three times this year. The risks are biased to them doing more, rather than less. While growth is running ahead of trend, the unemployment rate is below the non-accelerating inflation rate of unemployment (NAIRU) and the Fed funds rate, at only 1.50%, is well below neutral (currently thought to be 2.75%), so the Federal Open Market Committee (FOMC) will continue to hike rates.
Of course we need to acknowledge yet again that no-one actually knows where neutral is now, which is why much of the recent move higher in yields has been at the shorter-end of the Treasury curve as the market has moved to agree with the FOMC that three hikes are likely this year. The longer end is still sceptical about just how big a problem inflation is going to be and hence the flattening of the yield curve.
And remember we are now in the era of quantitative tightening. The FOMC’s balance sheet reduction process began in the last quarter of 2017 with the run-off cap increasing to $50 billion per month ($30 billion of Treasuries and $20 billion of agency debt and MBS) by the end of 2018. That means around $250 billion of Treasury debt maturing in 2018 that the FOMC will not reinvest.
3) US budget deficit is rising
After an impressive improvement in the six years to 2015, the US Budget deficit is deteriorating again. Sure, some of the factors behind this deterioration are temporary such as the costs of natural disasters including hurricanes and wildfires. But there is an underlying structural deterioration relating largely to demographics and the initial impact of the tax reform bill will have a negative impact on revenue collection. We will therefore see further deterioration in the deficit and increased net issuance. So far, broad opposition in Congress to increasing Federal debt has generated much political tension and brinkmanship but no actual debt or deficit reduction strategies.
So the fundamentals support higher yields in 2018, though we expect this to remain gradual. The move higher in global yields will be supported by other major central banks’ desire to exit from extraordinary monetary stimulus including, surprisingly Japan, though we wait for next bank of Japan meeting for clarity around their intention last week in announcing a reduction in asset purchases. New Zealand has performed well in this environment as the RBNZ appears likely to remain on hold for most of this year, if not into 2019. Any further out-performance from here appears likely to be contained to the short-end of the curve.
The key risks to the view of higher yields remain a weak patch in growth or another weak patch in inflation. And while we don’t worry too much about the market’s ability or willingness to absorb increased Treasury supply this year, higher yields will be necessary to clear the market. Rumours last week of China looking to reduce its purchases of Treasuries, later refuted by a Government official, shows the market’s sensitivity to the supply issue.
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