Twelve months ago, the main concern in bond markets was an increase in inflation expectations, particularly in the US, since 2020 was going to be a crucial year for the Trump administration in terms of his re-election campaign.
Expectations of further fiscal stimulus designed to boost the economy were starting to get priced into US bond markets, and the global economy more broadly, with the US 10-year yield rising from lows of 1.5% in September 2019, to close to 2% during the last quarter of 2019.
We’d also seen a steepening of the 5-year yield and 2-year yield spread from an inverted state, back into positive territory during the last quarter of 2019, with the US Federal Reserve expected to stay on hold throughout 2020, and optimism about a pickup in global trade in the wake of the ratification of phase one of the US-China trade deal.
Five-year inflation expectations were also on the increase, with US expectations above 2%, while in the UK estimates had risen from 3.4% to 3.7% by the end of Q4 last year. In the EU, the outlook was weaker but nonetheless there was some optimism that the weak deflationary outlook was starting to turn around, with a rebound from lows of 1.12%, to a high of 1.35% by the middle of January.
Pandemic prompts bond yields collapse
Unfortunately that was as good as it got as the spread of the coronavirus pandemic out of Asia and into Europe and the US upended the global economy, and prompted a sharp reversal in economic activity, as well as aggressive policy action from global central banks to avert a huge economic shock.
This slump is perfectly illustrated by the collapse in bond yields as the Federal Reserve, Bank of England and other global central banks slashed their headline rates in March, as well as boosting their asset purchase programmes in response to the spread of the virus.
To illustrate how quickly the economic outlook changed, one only has to look at what Fed chair Jerome Powell was saying at the end of January, when he expressed cautious optimism about the US economy, with the likelihood of steady growth in the jobs market.
Just four weeks later, on 3 March, the Fed cut rates by 50bps, stating that it recognised the potential economic significance of the evolving situation, and was willing to act decisively. Only 12 days later, on 15 March, the Fed acted again, cutting rates by another 100bps to near zero. The US central bank also reintroduced forward guidance and restarted large-scale asset purchases, as well as co-coordinating swap lines with the likes of the European Central Bank, Bank of England, Swiss National Bank and the Bank of Japan.
The Bank of England also cut rates twice over the same period, from 0.75% to 0.25% and then 0.1%, while also increasing the size of its own bond buying programme. The response from the ECB was much more constrained given that its policy rate was already below zero, which meant that the only tool really available to them was more bond buying. This took the shape of a €750bn pandemic emergency purchase programme (PEPP), which was announced on 18 March, and which was then increased to €1.3trn in June, as well as being extended to the end of June 2021.
Bond prices soar as yields plunge
Unsurprisingly, the net effect of these measures was to send bond prices soaring and yields plunging, as fears of a global depression took hold. Oil prices also collapsed, with WTI prices briefly going negative to the tune of -$38, falling from a February peak of $53 a barrel, most of which has since been reversed.
The impact of these large-scale stimulus packages, economic shutdowns and resultant reopenings are encapsulated quite nicely in the US 5-year and 2-year treasury yields in the chart below, and the spread between the two. It’s also notable how flat these short-term yields have remained in contrast to the rebound in the US 10-year yield.
US 5-year and 2-year treasury bonds spread chartSource: Bloomberg
As we come out of the other side of this year’s economic shock, it’s interesting to note that forward inflation expectations are higher than they were at the end of last year. Given the deflationary shock that has just hit the global economy, this is a little surprising to say the least. The extent of the economic damage that is yet to manifest itself as a result of the changes to the global economy are likely to take place over the next five years.
At the end of last year, 5-year inflation expectations for the US were at 2.07%, and have shifted upwards to 2.3%, while in the UK we’ve seen a smaller rise from 3.54%, to 3.61%. It’s a slightly different story in Europe, where these inflation expectations have declined from 1.32% to 1.24%, year-to-date, though on the plus side these indicators are all trending up from their March lows.
These low levels will be a particular worry for the European Central Bank, which has an inflation target of 2% and where headline inflation is currently anchored near 0%. The rise in the euro this year by over 4% against a basket of currencies is not helping, along with a rise of nearly 8% against the US dollar. A sharp narrowing of interest-rate differentials is helping to feed a deflationary bias that is going to be enormously difficult to push back against.
Nonetheless, the trend higher in forward inflation expectations does speak to a concern that all the widespread monetary and fiscal support of the last few months will unleash some level of inflation over the next 12 months, in the form of higher prices for goods and services, as demand starts to pick up, and we get an economic recovery.
Five-year inflation expectations chartSource: Bloomberg
It’s important not to underestimate the positive effects of the news about a successful vaccine rollout, which could unlock further economic gains and a recovery over the next 12 months. As a consequence, there will be a concern on the part of central bankers about the glide path of the current rebound in bond yields, given the high levels of fiscal spending that have been taken by governments across the world this year, and which as yet, hasn’t trickled down into the wider economy.
One of the main reasons countries have been able to borrow in the way they have done, is down to the very low levels of interest rates, as they are now. Governments will want borrowing costs to stay this low, which means central banks will be incentivised to manipulate or keep a lid on the longer end of the maturities curve. As was the case 12 months ago when there was a barrier at 2% on the US 10-year yield, we can expect a similar barrier at the 1% level, which by and large has constrained every rebound since the record lows of 0.32% in early March.
The Fed will more than likely want to try and keep a lid on this 1% level, as illustrated in the chart below. Its guidance that rates are likely to remain where they are through until 2024 would seem to underscore this commitment, however markets have a habit of moving in a direction that sometimes you don’t want them too.
How the US central bank manages this, along with its relationship with the new US treasury secretary, and former Fed chair, Janet Yellen, will be key in managing these expectations.
US 10-year treasury yield chartSource: Bloomberg
The rise in inflation expectations, as well as yields, is certainly welcome news in terms of a normalisation, however we can’t escape the fact that US and UK yields are much lower than they were a year ago.
The US 10-year yield has fallen from 1.92% at the beginning of the year to 0.92% now, while UK gilt yields have also fallen sharply from the start of the year, when they were at 0.82%, to below 0.3% now.
German bond yields have also fallen, from -0.23% to -0.63% and unlike its counterparts in the US and UK, shows no signs of reversing the declines in the wake of their March rebound, with lower peaks in June, September and November.
Germany 10-year treasury yield chartSource: Bloomberg
This weakness in European yields, which has been happening for most of the year, does not bode well for the euro area, indicating that it’s sliding into a ‘Japanification’ of yields and possible stagnation. The risk is that it drags the rest of the world down with it, particularly since we are seeing rising signs of deflation out of China, in the guise of a weaker inflation reading in its latest consumer price index (CPI) data. In short, there seems little likelihood of any upside risk in rates on the part of central banks over the next 12 months, with some risk of further easing of monetary policy.
Negative interest rates
There has been much discussion around negative rates on the part of the Fed, as well as the Bank of England. The Fed appears to have ruled out the prospect, while the Bank of England has said it’s up for discussion. It seems unlikely that the UK’s central bank will go down the negative-rate route, given the divisions already present on the Bank’s monetary policy commission. The briefings that there are economic benefits to such a policy aren’t matched by the available evidence, and it would be hugely controversial if the bank were to proceed with such a move.
Much will depend on how the global economy evolves over the next few months and whether we see a decent recovery, in the wake of the vaccine rollout programme which is expected to accelerate in earnest from January 2021.
At the moment we’re in the ‘early optimism phase’, where vaccines are rolled out with no side effects, and there are no setbacks in the form of further infection waves. This would suggest that we are in the foothills of a recovery, and as with any recovery there could be some setbacks to come in the year ahead.