Update Bonds: Is it all about inflation?
Bond yields started the week by creeping up further, continuing the trend of rising yields seen since December last year. This occurred until Wednesday, when yields fell sharply following the US inflation report.
US core inflation finally declined again, the first time since July, breaking the recent string of data that had increased the odds of a “no-landing” scenario in the US. In a no-landing scenario, both growth and inflation are not declining, meaning the Federal Reserve will not be able to cut rates further and may even have to hike at some point. This is therefore negative for bonds, and also potentially less positive for risky assets, than a scenario in which inflation falls and growth continues. So are markets back in a situation where it is all about inflation?
To some extent this is true. That may sound surprising with Trump’s inauguration coming up next week. From Trump’s campaign rhetoric, we know his focus may be on tariffs, taxes and immigration. Investors, however, have no clear guidance regarding the form, magnitude and timing of Trump administration policies. While Trump’s inauguration is indeed a major factor for markets, it is mainly due to the impact his policies could have on inflation. And if inflation remains too high, his policies could add fuel to a fire.
The rise in US Treasury yields has not been a huge surprise for us. We have been wary regarding US Treasury yields, due to the continued strength of the US economy and the impact the upcoming Trump administration may have. What did surprise us, however, is how Bund yields have been rising pretty much in tandem, and this is hurting our long euro duration positioning. Although higher US Treasury yields will always add upward pressure to yields globally, we think that over the past months the impact has been exaggerated.
In Europe, the economy is much weaker than the US and disinflation looks like a safer bet. Furthermore, we think any US tariffs will be more of a drag on growth rather than giving a push to European inflation. We therefore believe that the European Central Bank remains more likely to cut rates, and to cut more than the US Federal Reserve. And we continue to expect that the divergence in monetary policies will ultimately drive divergence between the yields of US Treasuries and Bunds. We therefore are maintaining our long euro duration positioning.
Thomas Smid