NN IP: Stabilisation in inflation expectations
Although the 10-year real yield has fallen back below “pre-Sintra” levels, the nominal 10-year Bund yield has not because market-implied inflation expectations have increased over the same period. Meanwhile market-implied Fed rate expectations have flattened significantly.
German 10-year real yield falls to pre-Sintra levels
Since the beginning of the year we have observed a very slow, but steady increase of the German 10-year real yield. The real yield increased from -117bp to -90bp before Draghi’s Sintra speech which triggered a rapid rise in government bond yields. During that phase the 10-year real yield rose further to -66bp in Germany. In the second half of August and during September yields fell back again. Again, the correction was taking place in the real yield component. The Sintra speech-driven rise in the 10-year real yield has completely been undone again. Actually, the 10-year real yield in Germany, which is currently at -101bp, is at least 10bps below the level of just before the speech. Therefore, the question is now if the very slow rising pattern we saw this year in the 10-year real yield is broken. Much will depend on the outlook for monetary policy. Against a background of expected tapering at the start of 2018, a continued slow rise of the real yield still makes sense.
However, the market will be looking for clues on the timing and speed. In the near term, this week’s ECB meeting and further out dynamics in both (core) inflation and perhaps also currency developments can be important drivers for the real yield as well. In addition, a rise of the US term premium (as a result of the start of balance sheet reduction) and the ongoing global economic recovery can exert upward pressure on real yields even in the absence of ECB tapering, but it will likely be a very slow rising trend in the real yield.
Market-implied inflation expectations are holding up
Although the 10-year real yield has fallen back below the pre-Sintra speech level, the nominal 10-year Bund yield has not. The reason is that market-implied inflation expectations have increased over that same period by about 25bp. Figure 2 shows some significant moves in 5y5y forward market-implied inflation expectations over the past year. When the focus was on reflation during late 2016 we saw a significant increase in inflation expectations, but about half of that increase was undone again in the first half of this year. Since then, we have seen a relatively stable environment of inflation expectations, which have even increased a bit since June.
Market-implied Fed rate expectations flattened significantly
Houseview 36 2017 Fixed Income - Figure 3Figure 3 shows in orange the actual development of the effective Fed Funds Target yield. In addition, market expectations (taken from Fed Funds future pricing) are shown at the beginning of this year (blue line) and the current implied path (grey line). The graph shows that the hikes in March and June were not expected at the beginning of the year, but at the same time the market has not extrapolated this pick-up in hiking frequency for the coming year. Rather to the contrary, the current implied Fed hiking path is substantially flatter than the assumed path at the beginning of the year. For this year the market has priced 13bp and for next year 18bp.
In addition to very limited expected Fed rate action, also the positioning in 10-year Treasuries continues to be very long. Between February and May, the 10-year US Treasury positioning moved from a significant net short positioning to a significant net long positioning. The long positioning has started to fall a bit, but the level remains extreme in comparison to the positioning over the past 5 years. Both Fed pricing and investor positioning argue for a short duration position in the US.