Broadly, we see above-trend growth in all major regions of the global economy. Following an extended period of upward revisions to growth forecasts, however, it will become increasingly difficult to surprise the consensus to the upward side and markets may be vulnerable to disappointments.
We believe risk for global yields is skewed to the upward side of the forwards in the medium-term. We expect the main drivers to be higher global real interest rates and an upward creep in inflation expectations.
Source: Fulcrum Asset Management
Although recent, relatively benign inflation reports may continue to distract focus away from the prospect of reduction in central bank policy accommodation. We anticipate the forward path of the global short rates gradually to be re-priced higher.
Some re-building of term premiums associated with the gradual reversal of the unconventional policy easing is likely to underpin higher global yields.
Fulcrum’s five global macro themes
Robust global growth – The major advanced economies are growing above-trend with emerging economies following closely behind. We identify China as the main risk to the outlook, though economic growth has stabilised close to 7.0 per cent.
Elimination of spare capacity – There is a growing number of both developed and emerging economies running at full employment. The eurozone is a standout exemption, on an aggregate level.
Gradual upturn in global inflation – Inflation is still running below most of the major central banks’ targets but we anticipate a gradual increase in wages and prices in the advanced economies. A further increase in oil prices should also see headline inflation rates drift higher.
Monetary policy tightening – The Fed is leading the way in this tightening cycle, followed by Canada and the UK. Elsewhere, in the eurozone we expect a gradual shift toward a less accommodative policy from the European Central Bank. In Japan, there is the potential of the removal of the yield curve control. We now see a broader group of countries likely to initiate their interest rate normalisation process expanding in Central Eastern Europe, Emerging Asia and Latin America.
Political disturbance – A number of political events are likely to impact financial markets, including the implementation of US tax reform along with other policy initiatives, the US mid-term elections, the Italian elections as well as a number of elections taking place across the globe (e.g. Sweden, Malaysia, Brazil, Mexico).
One thing also worth keeping in mind is global cyber-attacks, which have the potential seriously to disrupt economic activity.
Fulcrum’s five bond themes
Bond valuations in the major markets appear expensive, with momentum, though, providing more mixed signals.
We note the following factors in forming our assessment:
Real yields – Real yields in the US, Australia and Canada have increased from 2016 lows. In the UK, Japan and Germany though yields remain negative. Real yields in all major bond markets, except Japan, are close to one standard deviation below their long-term historical average. The five-year, five-years’ forward (5y5y) real yield in US Treasury inflation-protected securities (TIPS) is about 0.7 per cent – significantly below long-term trend real GDP growth and below the end-2016 level.
Breakeven inflation – 10-year breakeven inflation rates have recovered close to the levels of mid-2014 before the slump in the price of oil, with the notable exception of Japan. The 5y5y inflation swaps have increased since mid-summer with the US now yielding 2.3 per cent (the Fed’s own measure using the breakeven inflation rate is 2.0 per cent). The eurozone, on the other hand, has traded decisively higher since mid-year to 1.7 per cent, though still faring below the ECB’s inflation target.
Source: Fulcrum Asset Management
Yield curve slope – The slopes of two-year/10-year curves are still below their long-term average in all of the major markets except the UK and Australia.
Short rate forwards – The market is pricing US short-term interest rates below the forward guidance path implied by the Fed for this year onwards. Whereas overnight indexed swaps are pricing 1.9 per cent for end-2018 and 2.1 per cent for long-term, the Fed indicates 2.1 per cent and 2.8 per cent, respectively.
Momentum – Signals have turned mildly bearish, with the average 10-year yield (of the major bond markets, excluding Japan) above the 50-day moving average, which in turn has crossed above the 200-day moving average.
Andy Bevan is director of research and Elina Theodorakopoulou a portfolio manager at Fulcrum Asset Management. All views are their own and should not be taken as investment advice.