Bond yields take us by surprise
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Global macro-economic momentum slowed sharply at the beginning of the year but shows signs of having troughed, with global macro surprises, which typically lead global manufacturing PMI new orders, starting to rebound. However, while equities, and very recently cyclicals have all started to respond to the turn in the macro cycle, bond yields have not. Interestingly, it’s not that a substantial shift up in yields looks to have been warranted and the current level of macro surprises is consistent with bond yields being unchanged over the past three months. For the sake of completeness if we focus only on growth indicators, such as US earnings revisions or ISM manufacturing new orders, we would have expected bond yields to have risen over the past 3 months. Yet the performance problem for multi-asset funds underweight fixed interest is that bond yields have actually been falling, off 20bps on average since the start of the year, and the fall has accelerated over the past two weeks.
The fall in bond yields this year has caught consensus – and ourselves – by surprise, and we can identify several reasons for this decoupling of bond yields from an improving macro backdrop.
First, there is the expectation that the US Federal Reserve is more dovish than hitherto, with lower expectations for terminal interest rates. Thus the terminal rate on the Fed’s dot charts has fallen from 4.2% in January 2012 to 3.9% on the latest projections published in March, and FOMC member William Dudley observed on 20th May that “the level of the federal funds rate consistent with 2% PCE inflation over the long run is likely to be well below the 4.5% average level that has applied historically when inflation was around 2%.”
However, a more dovish stance from the Fed should have supported both the gold price and higher inflation expectations, and driven a steepening of the yield curve between five and ten years – yet inflation expectations are flat year to date, the yield curve has flattened at the long end and the gold price has continued to fall.
There is an international dimension to bond yields – so for example although US yields have been moving lower in absolute terms, the yield premium they offer over German bund yields is close to a 10-year high and German bund yields moved sharply lower following May’s ECB press conference, at which Mr Draghi appeared to pre-commit to a rate cut at this week’s rate setting meeting. But this argument doesn’t seem that strong in that if rate differentials were in focus, we would have expected to see a strengthening of the dollar.
Technical factors may also have played a part with the possibility that bond prices have been pushed up by short covering in a period of constrained liquidity.
As to what lies ahead, the inconsistency of accelerating economic momentum and earnings revisions combined with falling bond yields, can be resolved either by yields moving higher or economic growth retreating. The data presently support that it’ll be bond yields that go up, and there do seem to be upside risks to US GDP growth, with upward pressure on yields intensifying if the US jobs market continues to tighten. Meanwhile household leverage is back to its pre-crisis trend, investment intentions (on the Philly Fed series), which have tended to lead core capital goods orders in the US, are strong, mortgage applications for house purchases have picked up from their Q1 trough and cyclical drivers of inflation are no longer falling, especially in the housing market. The other issue is that the start point isn’t neutral – bond yields look too low even without accelerating growth.
Focusing in on the UK fixed interest markets, we expect the FPC to take the lead in controlling risk in the near term, and that the Official Rate will remain at 0.5% for the rest of this year, before rising to 0.75% in Q1 next year, finishing 2015 at 1%. We see 10 year bond yields rising slowly but steadily, broadly as follows:
End: Q114 Q214 Q314 Q414
10yr bond yield %: 2.72 2.95 3.05 3.15
