For the last few years central bankers have tried in vain to jumpstart the inflation fairy with little if any degree of success.
For a while in the months after 2009 we did see a sharp rise in commodity prices in the wake of a weaker US dollar, but this proved to be somewhat short-lived, as from 2011 chronic overcapacity saw these gains unwind over a five year period, prompting concern that the world was going to hit a long period of deflation.
Over a period of five years the Reuters CRB Index dropped from highs of 370 in 2011 before finding a base of 155 earlier this year, a decline of 58%, helped in no small part by significant declines in oil prices to multi year lows along with a fall in broader soft commodities as well.
This period of overcapacity in the commodity sector appears to be drawing to a close and the lagging effects of falling prices are now starting to fall out of the inflation numbers. This transition started to manifest itself at the turn of the year, just before commodity prices formed a base in the first part of this year.
Rising debt levels alongside an extended period of government fiscal retrenchment also helped put the brakes on prices, while central bank determination to keep the cost of borrowing low helped fuel a bond market rally that does appear to now be showing some signs of tiredness.
The election of Donald Trump as US President in November could well be the catalyst that prompts the end of this decades long bull market in bonds, and a potential turn in the low interest rate cycle.
While many a bond trader has ended up getting burnt in trying to call a top in the bond market in the last few years this time could well be different, though I’m also sure these words were also uttered on previous occasions where traders were tempted to call the top.
In the last few months there does appear to be some evidence that this may be about to change, though particularly since we are now starting to get the first signs of a turnaround in inflation.
In China we’ve seen producer prices move sharply into positive territory for the first time in over 5 years, while inflation in the US, EU and the UK has been trending higher for the best part of this year.
In the UK we’ve also seen a sharp rise in factory gate prices, and while a lot of that is down to the decline in the pound in the wake of the Brexit vote, inflation was already trending up prior to the vote in any case.
Earlier this month CPI inflation in the EU hit a 31 month high, while UK CPI hit its highest levels since October 2014, while US inflation is even closer to the Federal Reserve’s 2% target level.
This rise in inflationary pressures and the prospect of higher inflation expectations has quickly been reflected in lower bond prices and higher yields, while expectations about a Trump Presidency’s plans for a fiscally expansionist investment policy along with cuts to regulation and tax rates has reinforced that.
As can be seen from the chart above while UK bond prices got a sharp shock higher in the wake of the UK vote to leave the EU in June, as further stimulus got delivered US and German prices peaked at the beginning of July and traded sideways for most of the summer before sliding lower at around the same time oil prices started to look a lot firmer.
While the slide in gilt prices has been sharper they have had to readjust from being pushed much too high in the first place, as a result of the August stimulus from the Bank of England which as time passes looks to have been a bit premature.
More importantly we’ve seen US Treasuries break a key long-term support level as have German bunds which might suggest that we could be on the cusp of a significant move higher in bond yields.
Inflation expectations are already up sharply since the summer with UK 5Y5Y at 3.575%, its highest level since mid-2013, while in the EU we’ve seen the same indicator move from lows of 1.25% in the summer to 1.715% now.
In the US the same measure has jumped from lows of 1.792% to 2.457%, which if you measure it against the current level of yields on UK, US and German debt means that yields have room to go quite a bit higher.
The US 10-year chart looks particularly interesting from a price and yield point of view. On the price chart we’ve broken below a key support but have as yet held above the lows in 2013, near 123.00.
On a yields chart the case for higher yields in the US looks more powerful with a break in the down trend that has been in place since 2007.
On the basis of this breakout US 10-year yields look set for a test of 3%, which if we see it could well have ripple out effects for the rest of the world, particularly if China’s recent inflation spike also ripples out in the global economy.
If 2016 has been a year of surprises, then 2017 could well be the year of a bond market sell-off and higher yields, particularly since UK gilt markets and German bund markets are also showing similar signs of weakness.
Time will tell but the omens for higher yields look ominous, particularly since central banks want a steeper yield curve.
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