Bonds sink but still no inflation

Mid-Week Bond Update

Bonds sink but still no inflation

A sea of red spread over major bond indices over the past five trading days, as improved global growth optimism, strong US corporate earnings, rising merger & acquisition activity and renewed trade tensions led some investors to question, again, whether the end of the 30-year bond rally is finally here. US president Trump’s first State of the Union speech seemed to disappoint investors – as did his inaugural speech...

one year ago -, sending Treasury bond yields lower. The reaction, however, was not enough to reverse the week’s trend: the world benchmark US Treasury 10-year yield reached 2.73%, the highest since 2014.

Despite all the noise, inflation continued to remain subdued: the US Federal Reserve (Fed)’s preferred five-year inflation expectations measure kept the 2.05% level it had one week ago, and still hasn’t recovered its 2015 level, while in Europe, the actual inflation rate slowed down to 1.3% in January, as expected, but below December’s 1.4% increase and still well below the European Central Bank’s (ECB) 2% target. Also sending less optimistic signs, oil fell amid rising stockpiles, while US fourth-quarter Gross Domestic Product and new home sales data missed estimates. Emerging Markets survived the week mostly lifted by their rising currencies: the Brazilian real, for instance, soared after a court upheld a corruption sentence against former and left-wing leaning president Lula, reducing his chances to run in October’s presidential election. Colombia cut rates to 4.5%, from 4.75%.

 

ON THE RISE

Euro - European banks momentum? The European currency continued to rally against the US dollar, taking its one-year gain to 15%, the best performance among developed market currencies. The region’s economy grew by 0.6% in the final quarter of 2017, taking the annualised rate to 2.7%, above the US’s 2.5%. Once struggling French and Spanish economies advanced at a high rate. The region’s Composite Purchasing Managers’ Index (PMI) also rose in January to a new post-crisis high of 58.6. Despite the ECB’s efforts to reassure investors its monetary stimulus is still key to sustain growth, European sovereign yields edged higher, with the German bund five-year yield touching 0% for the first time since 2015. Despite the sovereign sell-off, some corporate sectors could benefit from the region’s momentum: according to Western Asset, European banks could improve their profitability as yields curves steepen and also on the back of their improved fundamentals. As seen on the chart, the average European bank debt-to-equity ratio has steadily fallen since the financial crisis, reducing the premium that investors demand to hold the asset class. More good news ahead?

 

European banks’ debt discipline cuts the premium investors demand

European Banks Debt

Source: Bloomberg Barclays as of 31 January 2018. The Average Debt-to-Equity ratio has been computed using data from 24 of the 26 banks that integrate the Euro Stoxx Index. OAS is Option Adjusted Spread and is measured in basis points in the right hand side (RHS) axis. Euro-Aggregate Banking sector is part of the Bloomberg Barclays Euro Aggregate Corporate Index. Please see disclaimers for definitions.

 

Washing machine-gate: Is China looking the other way? The price that US consumers pay for washing machines and solar panels could increase after the country unveiled new tariffs on both products. Chinse officials were quick to say the protectionist measure was a misuse of trade tools, increasing investors’ concerns of renewed trade tensions between the two countries. But far from engaging on a trade war, China has seemed more focused on its goal to make the renminbi a global reference currency, not one that moves to serve its trade agenda. The renminbi actually rose almost 2% against the dollar over the past five trading days – far from the typical reaction in a trade war, in which currencies tend to weaken to foster exports. This week’s renminbi rise brought the Chinese currency to its highest level since August 2015, when the country rattled global financial markets with a devaluation.

 

ON THE SLIDE?

Treasuries get hit – but where is the inflation? US Treasuries sold off over the past five trading days on expectations that improved global growth, strong corporate earnings and the new domestic tax cuts will ignite inflation and perhaps accelerate the Fed’s planned rate hike outlook. Long-maturity Treasuries suffered more than any other asset class, down 1.3% over the past five trading days, as they tend to be more inflation-sensitive. The asset class has lost 4.1% over the past 1-month period. Inflation, however, still seems to be missing in action: not only did inflation expectations remain flat this week, but economic growth and housing data also missed estimates. Wage growth, one of the key drivers of inflation, also seems stagnant, if not negative. As seen on the chart, a falling participation rate in the US job market has helped contain labour costs, which have recently fallen. Despite these trends, inflation expectations have slightly increased over the past few months. Click here to read more about why inflation may remain subdued in the US and globally, according to Ken Leech, Chief Investment Officer of Western Asset.

 

Inflation expectations rise, but labour costs fall: Are Treasuries over-sold?

US Treasuries Inflation

Source: Bloomberg as of 31 Jan. 2018. Please find definitions in the disclaimer.

 

UK Economy – missing out? Despite extending the transition period before Britain finally exits the European Union, the country’s economy is starting to feel the bite of its decision to leave the world’s second-largest trading block. The UK economy grew 1.8% last year, the slowest pace in five years, lagging behind European and US growth, which seem more synchronised with the general global upwards trend. According to Bank of England governor Mark Carney, Britain’s economy is about 1 percentage worse off than it would have been without the Brexit decision, with the gap increasing to 2 percentage points this year.

 

Source for all data: Bloomberg and Barclays Capital as of 31 Jan. 2018, unless indicated.

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