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The threat of normality

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Many pundits have falsely called the end of the bond-bull market. However, a number of factors may coincide over the coming year that could give such predictions added weight.
In recent years, tightening monetary policy initiatives by one central bank have often been met with further loosening by others. For example, the Fed’s decision in 2014 to unwind its QE program was followed by an even larger intervention by the Bank of Japan. In 2015, when the Fed was beginning to raise rates, the ECB accelerated its loosening of monetary policy. As we head into 2018 it would appear that central banks are united, if somewhat reluctantly, in looking to undertake a tightening of monetary policy. In fact, the change in global monetary policy may be so pronounced that 2018 could be the first time in over a decade that central banks actually withdraw money from the market.
The US Fed is undoubtedly the most committed to the normalisation of monetary policy, having increased rates three times since 2017. Despite new leadership, the Fed looks set to continue on this path with a possible three further increases in 2018, and may come under intensified pressure to increase the pace of shrinking its balance sheet - a process it cautiously began last year. Even the ECB, which has been one of the most committed central banks to loosening monetary policy, appears focused on tapering: its bond-buying program has been halved to €30bn a month, with some analysts suggesting the program could end altogether by the end of 2018. Despite these projections being optimistic, confidence in the eurozone is growing and one shouldn’t be surprised if talk of rate increases begins later this year. Even the UK, an economy to some extent in limbo, will taper its program in 2018. Further rate increases are not unfeasible.
The Bank of Japan, one of the staunchest advocates for stimulus, has reduced its asset purchasing program; although the bank appears committed to keeping the 10 year rate below 0%. However, the growing momentum behind tapering was evident last week as US treasuries hit a ten-month high following a significant sell-off, a market move that was certainly overdone but nevertheless demonstrates the markets’ sensitivities around the issue of tapering and the real possibility that the bull-run might be nearing an end.
Central banks’ tightening of monetary policy will initially be slow and veiled, so as to avoid causing shocks to the markets that would risk the hard-fought economic recovery. As such, this alone is unlikely to be enough to move markets significantly where the underlying economies are openly dependent upon ‘cheap’ credit. For this to occur we will have to see evidence of inflationary pressure in the coming years.
Analysts are relatively sanguine about the inflationary prospects of many of these economies as structural and technological changes appear to have a dampening effect. In the US core inflation is at 1.7%, below the target rate, whilst wages are only growing at 2.5%. In Europe and Japan inflation expectations are circa 1.5% and 0.5% respectively, and in the UK above-inflation levels of 3.00% appear to be driven by currency factors that are likely to fall out of calculation in due course. These lacklustre figures would help explain why long term interest rate projections remain stubbornly flat.
Yet one should be cautious to not put too much emphasis on inflation’s recent lacklustre performance. With many economies nearing full employment and continuing to grow, it might take less than one expects for inflationary pressures to grow. For example, with a cocktail of equity markets at record-breaking levels, healthy levels of corporate profitability and an increasing shortage of labour, it is feasible that workers will grow in confidence and overcome concerns about the impact of technological change on their jobs and demand higher wages. Alternatively, it could be the significant one-off stimulus of recent US tax reforms that jolts the economy and helps kick-start the Philips curve.
Even if inflationary pressures remain passive, traditional supply-side factors could see bond yields rise. Having seen a reduction in supply over the last 12 months, it is expected that 2018 will see over $500bn of new government-debt issues. This larger increase in supply isn’t large enough by itself to cause an end to the bull market but will add to the momentum.
Whether the expected increase in interest rate projections is enough to end the bond bull-market is unclear, but it is important to remember that with interest rates at such historically low levels any increase in interest rates will have a noticeable impact and will need due attention and consideration.
Looking to the week ahead, UK inflation figures are out on Tuesday and should show signs that the currency effect is fading from the data. This will be followed by retail sales figures on Friday, which should show some contraction. Wednesday sees the release of eurozone CPI.


All views expressed here are the Author’s own and are based on information available at the time of writing



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