Yields are on the rise
Author: Mark Weinberg
January 31, 2018
Bond yields have been moving steadily higher with bond markets pricing in higher inflation expectations and less restrictive monetary policy continuing the strong momentum last year. The global coordinated upturn in economic growth has supported a tightening narrative, though only the U.S. Federal Reserve Board and the Bank of Canada are expected to hike policy rates this year (the latter did so earlier this month). We have also witnessed stronger economic growth and hawkish tones from the European Central Bank. Mario Draghi stated last week that stronger economic growth is likely to push inflation higher, while the strengthening euro continues to concern the central bank.
Bond yields are on the rise
Source: Bloomberg, as of January 26, 2018
… supported by rising inflation expectations
Source: Bloomberg, as of January 26, 2018
Further, the Trump administration recently passed the ‘Tax Cuts and Jobs Act’, introducing the most sweeping changes to tax reform since President Reagan’s implementation of across-the-board tax cuts in 1986. This has fueled a further rise in yields as economic growth prospects and inflation are expected to rise. As well, the increase in supply of U.S. Treasury bonds in order to fund these tax cuts and increased deficits, combined with less purchases from the largest buyer in the world, the Fed, has supported the recent rise in yields.
Who will pick up the slack in the U.S.?
For years, the Fed has depressed yields by purchasing massive amounts of Treasury debt, but that has changed. As they continue to taper their balance sheet, it will take other buyers to step in to prevent yields from moving sustainably higher, barring a recession. So who will it be? It could be the private sector that picks up the slack left behind by the Fed, as other large purchasers, such as China look to reduce purchases over time. U.S. retail investors could also swoop in, though higher yields are likely necessary to entice greater purchases of Treasury bonds. This is because U.S. households have been decreasing their allocation to fixed income as rates were, and are still, too low, and as they have become increasingly more comfortable with stocks, considering equity markets continue to set new highs and as they became more distanced from the negative impacts caused by the Great Financial Crisis.
Ned Davis Research, as of September 30, 2017
Thus, it will be important to watch U.S. retail investors and their buying habits of U.S. Treasuries over the medium term. It is also plausible that other buyers could step in, such as commercial banks and global reserve fund managers, though with high-flying equity markets, strong global growth prospects, rising inflation and an underlying hawkish tone from central banks, it will likely take significantly higher yields, a correction in equity markets or worse, a recession, before we see these types of buyers emerge.
As the economic environment continues to improve and equities remain favoured, bond yields will likely be pressured higher. It is important to note that we believe that yields will gradually increase in this environment, but not on a sustained basis, and a further rise in bond yields will start to lure investors, including AGF, back into government bonds. As demand returns, this should help to suppress the rise in yields.
Commentaries contained herein are provided as a general source of information based on information available as of January 29, 2018 and should not be considered as personal investment advice or an offer or solicitation to buy and/or sell securities. Every effort has been made to ensure accuracy in these commentaries at the time of publication; however, accuracy cannot be guaranteed. Market conditions may change and the manager accepts no responsibility for individual investment decisions arising from the use of or reliance on the information contained herein. Investors are expected to obtain professional investment advice.
About AGF Management Limited
Founded in 1957, AGF Management Limited (AGF) is an independent and globally diverse asset management firm. AGF brings a disciplined approach to delivering excellence in investment management through its fundamental, quantitative, alternative and high-net-worth businesses focused on providing an exceptional client experience. AGF’s suite of investment solutions extends globally to a wide range of clients, from financial advisors and individual investors to institutional investors including pension plans, corporate plans, sovereign wealth funds and endowments and foundations.
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Written by
Mark Weinberg, ASA, ACIA
Vice-President, Portfolio Specialist Group
AGF Investments Inc.
