This time last year there was an expectation that we might start to see the first flickering of the inflation fairy that central bankers have been trying in vain to jump start since commodity prices peaked in 2011.
The five year slide in commodity prices that found a base at the start of 2016 was expected to herald a slow rebound in prices and a slow rise in bond yields and a gradual decline in bond prices.
For a while at the beginning of the year this looked like it was going to happen as expectations of a significant fiscal boost from US President Trump prompted a sharp move higher in five year five year inflation expectations, a selloff in bond prices and an expectation that we’d see the US Federal Reserve embark on a significant tightening of monetary policy.
We have seen three US rate rises since December last year and the Federal Reserve has also started to reduce the size of its balance sheet, yet yields on 10 year US treasuries have barely moved.
In stark contrast yields on 2 year treasuries have jumped from 1.19% to 1.79% while yields on US 30 year treasuries have sunk from 3.065% to 2.71% as the yield curve flattens out around the 10 year, which is just above 2.3%. If this trend continues this could present a significant problem for banks in general who rely on wider differentials to help boost their profit margins.
This would also suggest that markets appear to be pricing in a longer term benign inflation environment, even as short term rates move higher, on an expectation that while we could see further increases in interest rates, they are likely to settle at a much lower level than their historical mean average.
This belief may well be driven by the fact that consumer debt levels, as well as government debt levels still remain high, and in some cases are above the levels they were in 2008, at the height of the financial crisis.
It’s been a similar story for the UK yield curve with UK 2 year yields at 0.48% having started the year at 0.08%, while on the 30 year gilt we’re down 8 basis points from 1.875%.
As it turns out the expectation that Trump’s election would be the catalyst that prompted bond markets to roll over was misplaced, and as such turned out to be another false alarm, despite evidence at the end of last year that inflation was picking up.
The sharp rise in Chinese producer prices seen at the end of last year didn’t translate into a similar rise in CPI, in fact on any number of measures CPI inflation has trailed off after a strong start to the year, the UK notwithstanding, which has seen inflationary pressures increase as a result of a weaker currency.
The rise in inflationary pressures and the prospect of higher inflation expectations seen at the end of last year, and the beginning of this year turned out to be close to the higher water mark for inflation with the Fed’s preferred measure of inflation, PCE down from 1.9% at the beginning of the year to 1.3% now.
Even in Europe, having been as low as -0.2% in the first quarter of 2016, CPI peaked at 2% in March this year before slipping back sharply and is now at 1.4% with core prices even lower at 0.9%.
The UK has been the outlier in terms of CPI when it hit 2.9% in May before slipping back in the summer and then rebounding at the end of Q3 to hit 3%, but that can be largely put down to the Bank of England’s rather hasty decision to launch its monetary policy bazooka a year earlier which sent the pound sharply lower, and in so doing putting further upward pressure on import prices.
Having been premature a year ago in warning about a potential reversal in the bond market it pays to be more circumspect this time around.
Looking at inflation expectations on a five year basis it is clear that US inflation expectations are fairly benign (yellow line) slipping from levels above 2.4% to trade in a tight range between 2.2% and 2.3% for most of the second half of this year. It will be interesting to see how bond markets react if we see a break of this range.
In the UK the picture isn’t that much different, we are slightly lower, down from 3.52%, despite the reversal of last year’s rate cut, though since August we have seen expectations start to trend higher (green line) from lows of 3.3% to 3.44% now.
In Europe it is a slightly different story in terms of the overall direction of travel from the summer lows, with the white line showing a sharp rebound, but we’re still below where we started this year.
If US inflation expectations remain benign then it is quite likely that this narrowing of the yield curve is likely to continue as short term rates continue their rise, while longer term rates come down to meet them.
Much will depend on expectations surrounding monetary policy and while US rates are expected to rise further there remains very little clarity on how many rate increases we’ll get next year when Jerome Powell takes over at the Federal Reserve. This is because we still have no clarity on who will be taking up the three vacant Fed governor positions, all of which will be Presidential appointees.
Given President Trump’s problems he’s unlikely to want to appoint anyone too hawkish, lest they prompt a rebound in the US dollar.
As far as rates in Europe are concerned it is quite likely that there is more potential upside in short term rates in countries like Germany where 2 year yields are still negative to the tune of -0.7%, despite the prospect of the ECB tapering its asset purchase program.
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