A regime shift in financial markets? Demystifying the recent rise in yields

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1 Luxembourg, 23 Jan 2018 A regime shift in financial markets? Demystifying the recent rise in yields The 10 year US government bond yield recently touched the highest level since The yield on the 2 year pendant rose to the highest level since 2008 (figure 1). Many investors now ask themselves whether these moves mark the end of the decade long bond bull market or even an outright collapse. This would have wideranging consequences. The price of US Treasuries the mother of all assets is often seen as the most important price anchor in the global financial system, carrying a lot of information about markets and the economy. A reversal in the multi decade down trend in interest rates would mean a regime shift for markets and the economy, which in some peoples view have become addicted to ever falling interest rates. Are we there yet? Volatility in bond markets is expected to rise, but we don t think the recent market development marks a major trend reversal. The repercussions of Trumponomics, as well as inflation bottoming in the short term, might cause a repricing of the Fed, lifting core yield in the coming months, especially in the short end of the curve. Medium term however, we think the low yield environment is not under threat yet. Ultimately, the rise in yields is expected to be self-correcting to some extent amid front-loaded benefits from US tax cuts, still high leverage in most regions, demographics and no signs of accelerating wages. In order to come to grips with the rise in core government bond yields, let s first take a look at the drivers behind the moves. What is the mother of all assets telling us? 1. Trumponomics is the only game in town: It s important to note, that US treasury yields have shown a remarkable correlation with the ups and downs of Trump s policy agenda (see figure 2). In other words, the tax cuts have been a key driver behind the rise in yields. This is partly because the market believes that growth will be lifted in the short term and the Fed is more likely to hike in the wake of the tax cuts. Part of the story is of course also that the US deficit will be higher as a result of the tax cuts, increasing the supply of government bonds. Figure 1: Monetary tightening reflected in higher yields and a flatter curve, sparking bond jitters Figure 2: The ups and downs of Trumponomics are moving markets 2. All eyes are on inflation: US inflation seems to have bottomed for now as a lagged response to the cyclical growth improvement over recent quarters. This stands in contrast to the situation 12 months ago, when our inflation model indicated downside to US core inflation, making us bullish duration back then (see figure 3). The recent lift in oil prices although somewhat correlated with the above has most likely also triggered bond selling.

2 2 3. On top of this, central banks hawkishness undoubtedly has fuelled the rise in bond yields lately. This is not exclusively due to the aforementioned points, but both tax cuts and a cyclical inflation pick-up give the Fed cover for hiking rates, tilting the risk of the expected rate path to the upside. Adding to this trend, the Bank of Japan trimmed its bond buying and the European Central Bank is considering shifting its forward guidance in a more hawkish direction. Figure 3: Inflation outlook could give the Fed cover for its hiking path over the coming months Figure 4: Low unemployment is not driving wages higher The end of days for bond bulls? All this has encouraged market participants to increase their bearish bets on core government bonds. The abovementioned factors can continue to lift interest rates in the coming months. Trumponomics effect on US Treasuries as such implies higher yields near term (see figure 2), as the positives from tax cuts on the economy and earnings are front loaded and inflation is set to tick up a bit further (figure 3), although shelter components will weigh on inflation going forward. More medium term, we see no regime shift yet away from the lowflation environment. Hence, there are limits to how much core interest rates should rise. A structural rise in inflation (as opposed to the cyclical improvement indicated in figure 3) requires wage growth. Very low unemployment has not driven wage inflation higher in recent years. If wage inflation is not rising now, with unemployment in the US hitting the lowest level since the dot-com bubble burst, then when, one might ask (see figure 4). A key factor currently holding back wages is that baby boomers make up a large part of the US labour market. This group typically has high but relatively constant salaries. Once these workers retire, wage inflation should rise, as younger people face steeper wage curves. Nevertheless, we think this is a longer-term story, unlikely to affect inflation and interest rates over the coming 6-12 months. Parts of the fixed income market seem to agree that the current uptick in inflation is more cyclical than structural, as the market-based long-term inflation expectations are not moving much compared to short-term inflation expectations. This means the current rise in nominal yields pushes up implied real yields (see figure 5) and real yields matter for real growth. The rise in real yields leads to monetary headwinds, which results in slowing growth, although this normally happens with a time lag. The rise in yields, therefore, should have a selfcorrecting element to it. The economy is simply not ready to cope with significantly higher interest rates amid high leverage in most regions. Importantly, the withdrawal of quantitative easing at the Fed does not contradict this. Although the Fed started reducing its balance sheet, the US term premium (i.e. everything that does not have to do with the path of shortterm rates) decreased. This challenges the widely held view that central banks in isolation have manipulated the price of the mother of all assets significantly higher via a lower-term premium. In our view, the term premium is

3 3 low because investors view the risk of disinflation being higher than the risk of higher inflation. As long as this is the case, central banks changing course does not spell doom for bonds. In sum, we do not think this is the end of days for core government bonds as an asset class. Any significant weakness will be temporary and not the reversal of the multi-year bull market (see figure 6). Although rates could rise further in the coming months, we are likely to see lower rates still before entering a sustained upward trend, probably with a US recession in between. The risk to this view is that Trumps tax cuts finally create broad-based wage increases in an economy that arguably runs at full capacity. This would increase inflation and therefore corporate input costs, making margins turn down and incentivising the Fed to tighten even more forcefully. It would neutralise the positive growth effects from tax cuts relatively quickly a boom/bust scenario, in other words, resulting in a brutal rate rise and some kind of stagflation. Figure 5: Long term inflation expectations largely unchanged despite tax cuts Figure 6: All that matters is the mother of all assets entering a multi-year bear market? The impact on equities: It s a balancing act What are the broader asset allocation implications? Needless to say, if yields stay around current levels, equity investors can put their focus elsewhere. But given the trading pattern over the recent years, long dated real rates are at levels where the correlation between bonds and yields soon can turn negative, hence where rising real yields dampen risk appetite (see figure 7). In other words, a further spike in yields could potentially cause the equity rally to pause. But causality is key. A yield rise in tandem with higher growth should go hand-in-hand with rising equities. If yields outpace growth, e.g. because inflation is rising, caution is warranted. Currently, we are seeing higher rates but also upward revisions of growth estimates, which makes equity investors relatively relaxed. Rightly so as long as growth indicators hold up well and support economic optimism, equities are unlikely to be hit. But with growth estimates already being higher relative to recent trends, we are walking a fine line. The bar for positive macro surprises is being raised even as we speak. Markets enthusiasm at the start of 2018 might be dampened if growth does not turn out to be as strong as expected, while inflation is rising at the same time,. In that case, rising yields would quickly become problematic for risk assets. Longer term, if we are wrong and this actually marks a trend reversal on bonds markets, it would also lower equity returns on a structural basis, as constantly falling yields have been a major support for risk assets over the last decades (see figure 6).

4 Correlation 4 Figure 7: When do yields become a thread to the equities? Correlation between weekly equity returns and yield changes (since 2013) y = x R² = Y real rate Source: Macrobond, Bloomberg and Nordea Investment Management AB About Nordea Asset Management Nordea Asset Management (NAM, AuM bn EUR*), is part of the Nordea Group, the largest financial services group in Northern Europe (AuM bn EUR*). NAM offers European and global investors exposure to a broad set of investment funds. We serve a wide range of clients and distributors which include banks, asset managers, independent financial advisors and insurance companies. Nordea Asset Management has a presence in Cologne, Copenhagen, Frankfurt, Helsinki, London, Luxembourg, Madrid, Milan, New York, Oslo, Paris, Sao Paulo, Singapore, Stockholm, Vienna and Zurich. Nordea's local presence goes hand in hand with the objective of being accessible and offering the best service to clients. Nordea s success is based on a sustainable and unique multi-boutique approach that combines the expertise of specialised internal boutiques with exclusive external competences allowing us to deliver alpha in a stable way for the benefit of our clients. NAM solutions cover all asset classes from fixed income and equity to multi asset solutions, and manage local and European as well as US, global and emerging market products. *Source: Nordea Investment Funds, S.A., For further information: François Passant, , francois.passant@nordea.lu

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