Multiple upside risks for US bond yields

Posted on January 18th, 2018

In our post on Monday (The white trashing of the US dollar), we suggested that it may be too late and dangerous to sell the USD that is falling in the face of a rising yield advantage, tax cuts that should help boost the already solid recovery path in the USA, late in its economic cycle, and potential repatriation inflows.  There may be some reasonable explanations for the USD fall, such as speculation about QE unwind in Europe and Japan, capital inflows to EM markets, and the toxic political climate in the USA.  Sentiment towards the USD appears quite bearish and may remain weak despite a strengthening US economy and rising inflation expectations.  As such, a better strategy may be the consider the implications of a weaker USD in this context.  In particular, it should add to upside pressure on US yields. Below we discuss this and other reasons to see higher US and global bond yields.


Dollar weakness adds to inflation pressure

A weak USD should tend to help support commodity prices and lift USA import prices for all goods and services, generating a rapid and direct impact on headline inflation.   It should help boost export growth in both real and nominal terms, adding to total demand in the economy, further tightening the labor market and boosting business confidence and investment; generating longer lasting secondary inflationary effects that impact on core inflation.

The Fed is likely to see a weaker USD as contributing to the case for continuing with its projected path for three rate hikes this year, and raising the risk that it hikes faster if other real or financial indicators point to inflation risks.

The Bloomberg USD index is down 8.7%y/y, its steepest annual slide since 2011, this should boost import price indices.  With most of that annual fall coming in the last couple of months, it might be expected to have its peak direct impact on import prices in the next six months.

A Cleveland Fed report from 2015 said, “Our rough calculations, which are consistent with previous findings, suggest that, in general, a jump in dollar exchange rates can affect import prices for at least six months, but that the overall impact is fairly small. A 1 percent change in the Board of Governor’s broad dollar exchange-rate index lowers non-petroleum import prices by 0.3 percent cumulatively over six months.” (Exchange-Rate Pass-Through and US Prices –

By this assessment, as a rough guide, we might expect import price inflation (ex-petroleum) to rise from 1.3%y/y in Dec to around 4%y/y.

The pass-through from import prices to PPI indices is likely to be much less, perhaps only a quarter of this.  Still, this would be around one percentage point.  The pass-through then to core CPI is unclear, but it creates upside risks for the headline and core inflation.


Weaker dollar and stronger commodity prices

This analysis says nothing about the impact of a weaker USD on commodity prices.   This may already be contributing to a rise in oil and other commodity prices over recent months. Energy prices are up by around 20%y/y.  Due to base effects, this annual increase will rise further over the next six months, if oil prices remain unchanged, to around 50%.

This should have a direct upward impact on headline inflation data. The impact on core inflation is far more debatable, but it may tend to help boost inflation expectations, even if the Fed adopts its typical view that higher oil prices are likely to have only a transitory impact on inflation

Higher energy prices, some of which may reflect a weaker USD, is also likely to boost activity in the US energy sector, adding to industrial activity.  The US oil rig count may pick up after stabilizing over the last six months if the recent rebound in oil prices is sustained.


US inflation should start to recover between March and July

Core inflation fell sharply between Feb and July last year, due in part to a number of factors that are likely to be on-off and temporary. Monthly inflation readings have returned to more normal levels since August last year; as such annual inflation is likely to begin to rebound from March this year as base effects from low readings a year earlier fall out of the annual change.

In general, there are reasons to see upside risk to inflation readings throughout this year arising from a weaker USD, higher commodity prices, stronger US economic growth, and a rebound from recent low levels as base effects wear-off.


Tide turning in QE and foreign demand for US Treasuries

Market attention was directed to a rise in bond yields last week following reports that the BoJ had reduced its purchases of long-dated JGBs and Chinese officials had mused that they might reduce purchases of US Treasuries.  These stories contributed to a rise in US 10 year yields above 2.5%. (Treasuries recoup losses after strong US debt auction, 10-Jan –

Some have interpreted the BoJ’s reticence in buying long-dated bonds reflects a bias towards encouraging a steeper yield curve.  BoJ Governor Kuroda highlighted BoJ research into the optimal yield curve in November speech (Quantitative and Qualitative Monetary Easing, 13-Nov –  This has fueled speculation that the BoJ will raise its target rate for 10-year yields sooner than had previously been expected, perhaps before it reaches its inflation targets.

Others, including bond market legend and Janus fund manager, Bill Gross, note that QE expansion is drawing to a close.  The US is now running down its balance sheet, the ECB has halved its purchases to EUR30bn per month since this year began, and the BoJ has slowed its purchases since adopting yield curve control.

There is little doubt that the weight of demand from QE has placed downward pressure on bond yields.  Major central banks own about $15 tn of their own government bonds, representing around one-fifth of their outstanding government debt (Central banks hold a fifth of their governments’ debt; 15-Aug –

The FX market certainly appears to be reacting early to signs of a shift in QE policy.  The EUR and JPY have rallied sharply in anticipating of changes in QE.  The bond market, so far, has reacted more mildly.

Total QE is only set to slow in coming months, not reverse, at least until Q4.

The BoJ may well persist with QE well into 2018.  However, if yields globally are rising and the JPY weaker, it might consider raising its 10-year yield target. This would likely filter through to US and other bond markets to some extent.

It remains to be seen if a slower pace of QE will have an impact on yields.  But there is a risk that bond markets begin to build in a turn in the QE trend well before global QE moves into reverse.


How QE has depressed yields

The degree to which QE might be considered to have depressed bond yields globally is reflected in the term premium.  This is the additional yield that investors require to lock-in returns for the long-term instead of achieving the same expected return from rolling shorter investments.

If long bond yields largely reflect inflation expectations, real growth expectations, and the term premium. And more QE should boost inflation and growth expectations; then the term premium is likely to embody most of the depressing impact of central bank bond-buying.

Historically, the term premium is positive, averaging above 1%, suggesting there is a preference for holding more liquid investments.  However, a measure of the term premium generated by Fed researchers is near its record low reached in 2016, at -0.45%, suggesting that QE is exerting a heavy-weight on yields.

The term premium appears to have been significantly depressed. QE may have exhausted its depressing impact on yields, and the term premium may rise in anticipation, well ahead of, the end of QE programs. This creates upside risk for bond yields


 The term premium may rise if global market volatility recovers

The Janus/Henderson Global Head of Fixed Income, James Cielinski, was interviewed on Bloomberg TV on Monday and discussed his view on the bond market.  He noted that the term premium was depressed.  He also postulated that low global markets volatility tends to get expressed in a low term premium.

As such, he thought that an increase in volatility would also lead to an increase in the term premium (generating upward pressure for bond yields).

The low compensation for moving out the bond yield curve (essentially the term premium) is part of the broader phenomenon of low credit spreads and a steady low vol rise in global asset prices.

The low vol state of global asset markets may have lulled investors into a false sense of security over the stability of global markets.  Low vol, elevated asset prices, narrow credit spreads, and a depressed bond term premium are all part of the same phenomenon.  It has been generated in part by QE, and even a modest shift in QE could trigger a significant correction in a wide range of markets.

For reasons that may not be entirely clear, the market appears to have ignored the Fed rate hikes to date.  The long end of the yield curve has moved far less, causing curve flattening, equities have continued to trend steadily higher, and the USD has remained weak.

Looking ahead, it does appear that central banks are steadily removing accommodation and as they do, volatility in financial markets should pick-up.  Even if policy tightening does not, in the first instance, cause a sharp correction in asset prices, volatility may increase.  A rise in volatility should also contribute to a higher term premium.

Many commentators have looked at the flattening in the yield curve as a sign that an economic recession is looming.  However, Cielinski said that the Fed rate hikes and curve flattening might have been step-one. Step-two may be higher vol and higher long-term rates.


Only the lunatic fringe expects US 10 year yields to rise above 3%

Cielinski said that while there are widespread calls for US bond yields to rise modestly to say around 2.7% this year, few predict yields will move beyond 3%, other than the “Lunatic fringe.”

Cielinski himself thought yields would only rise modestly.  His colleague, bond legend Bill Gross, came out with a call that the US bonds had entered a “bear market” after yields broke 2.5% last week, declaring “25-year long-term trend lines broken in 5-yr and 10-year maturity Treasuries”.  But his latest report “Bonds, like men, are in a bear market” forecasts only a modest rise to 2.7% this year.

The market is on board a mild pace of Fed rate hikes and is willing to see that there is a modest rise in bond yields, but it views this as a benign scenario for the global economy and global equity markets.  The market is anticipating a mild tightening cycle that does not derail what they really care about, the steady rising trend in global equities.

There may be a lot of chatter about a bond bear market, but investors are not really anticipating it.  They are not positioning for it, they are more focused on staying on existing trends in equities and EM markets, and will do their best to ignore and dismiss higher bond yields as probably limited and not worth reacting to.

This view seems a little too convenient and suggests that there is a high degree of complacency in global financial markets.


Low inflation expectations

Part of the rationale for an at best only modest rise in bond yields is secular forces keeping inflation low.  A common refrain from many market commentators is that inflation is unlikely to rise much due to the forces of globalization and impact of disruptive technologies that are increasing price competitiveness.

The persistence of low wage inflation in the face of tightening labor markets and steady relatively low core inflation in many major and developing economies over the last 5-years or so has contributed to this benign view on inflation.

Low and stable inflation will see only a very slow removal of monetary policy accommodation and will continue to allow global economic growth to expand.  It seems investors no longer care much about looming constraints in labor and capital markets.

Low inflation expectations are a concern of the Fed and other central banks, and are a reason many policymakers are reluctant to tighten policy.

Whether this is complacency or not, it does suggest that the market has largely already built in persistent low inflation, or at least only a very mild rise in inflation.  As such, there is room for higher inflation outcomes to upset financial markets.  In particular, a rise in wage rates might be a wake-up call for financial markets.



Wage rate hikes

This may be the right time to highlight that Walmart said that it is raising their wage response to the recent USA tax cuts  Starting Walmart employee wage rates will rise from $9 to $11 per hour (+22%).

Yahoo finance reporters found that over 80 US companies had publically announced bonuses, wage increases or other kinds of benefits since Trump signed tax reform into law on 2 December.

These companies announced wage hikes, bonuses, benefits in afterglow of Trump tax reform –

This may only be anecdotal evidence, but the US labor market is tight.  There is a lot of political capital invested by the Republican Party in seeing their corporate tax cuts deliver higher wage growth. Corporations may feel more pressure than usual to spread the gains from tax cuts to their employees.  In fact, they may feel that they need to retain employees.


USA budget blues

Apart from the potential boost to domestic demand, the US fiscal deficit and Treasury borrowing requirement is set to rise to fund tax cuts.  At the beginning of 2017, the Congressional Budget Office (CBO) projected budget deficits of around 3% per year through 2019.   Beyond that it projected the deficit widening to reach 5% by 2027, reflecting higher outlays – particularly for Social Security, Medicare, and net interest.  They predicted government debt would rise from 77% of GDP in 2017 to 89% by 2027.

Beyond this 10-year horizon, the CBO said deficits would rise faster, if current laws remained in place.  It said, “Three decades from now, for instance, debt held by the public is projected to be nearly twice as high, relative to GDP, as it is this year—and a higher percentage than any previously recorded.”

The Budget and Economic Outlook: 2017 to 2027 –

The tax cut policy just implemented is forecast to add around $1.5 tn to the deficit over 10-years, around 7.5% of one year of current GDP growth.

But of course, the White House argues that its tax policies will pay for themselves by faster GDP growth. The CBO projections are based on GDP growth of a little over 2% per year.  Trump’s team see growth accelerating above 3%.

Incorporating the tax cuts, the FOMC projected real GDP growth of only 1.8% per year in the long run, and a relatively minor boost to GDP next year, revising up their projection from 2.1 to 2.5%.



Easy financial conditions argue for higher yields

Whether or not there is an inflation surprise, stronger and more synchronised global growth argues for higher bond yields.  Most agree that the global economy can withstand modest tightening in global policy. And central banks are likely to tighten, including the US to lean against financial stability risks.

Despite policy tightening to date, measures of financial conditions have continued to ease, suggesting that tightening to date has had little real cooling impact on demand or confidence and further tightening may be required to prevent over-exuberance in asset markets.

Easy financial conditions and their potential impact on inflation are also embodied in the New York Fed’s underlying inflation gauge.  This is designed to forecast underlying inflation incorporating a wide range of data including financial markets.  It is far above other core inflation readings (approaching 3%y/y), well above the Fed’s 2% inflation target, at a high since 2006.


Trade policy

Other commentators have pointed to the trade relations, including the renegotiations of NAFTA underway and posturing towards trade restrictions against China, as generating higher inflation risks.


Repatriation flows may weaken Treasuries

The repatriation of US multinational company retained earnings is expected to see a large net inflow of capital to the USA.  The new tax law requires companies to pay tax on these offshore earnings, albeit at a concessional rate, and there is no longer a tax incentive for companies to retain earnings offshore.

These capital inflows may or may not generate much demand for USD in the foreign exchange market.  Much of it (estimated at over $3 tn) is probably held in USD.

However, Bloomberg analysts make an important point.  Much of this hoard (they estimate $500bn) is held in US Treasury securities. And more may also be invested in other liquid bond markets.

Without the benefit of tax minimization, these companies will no longer have reason to leave cash sitting in low yielding assets. Their shareholders will demand that if they don’t have a productive use for these funds, they should pay it back to shareholders, such as in share buy-backs.

As such, the repatriation may generate significant selling pressure on US Treasuries and other fixed income securities, and higher demand for equities.  The combination of which is likely to add to upward pressure on yields.

Beware the $500 Billion Bond Exodus –