Climbing the wall of worry in bonds
What a week! Europe tortures itself with worries over the AstraZeneca vaccine, German voters desert Angela Merkel’s party and a pot at the European Commission accuses the British kettle of being black over banning vaccine exports.
In the US, Biden signs a massive fiscal stimulus bill and starts work on an even bigger one, which will probably include tax hikes. Global bond yields rise further on this and inflation worries, yet US equities reach new record highs. Meanwhile here in the UK, the vaccine roll-out continues at an astonishing pace and forecasters revise up the expectation for growth here as a result. We’ll try to make sense of it and discuss where we go from here.
Divergent progress of Europe and UK’s vaccine programmes
Europe’s worries over side effects from the AstraZeneca vaccine have prompted several governments to suspend its use temporarily. The experts tell us that all vaccines have side effects, whether it’s the flu jab or MMR, but those side effects are much less than the risk from the disease itself, otherwise the regulators wouldn’t authorise their use.
By contrast, the UK’s vaccine roll-out continues apace, and has allowed Boris Johnson and his government to recover some of the lost ground from the apparent poor performance on the pandemic last year. The decision to announce dates for further easing, all the way to 21 June, does raise the risk of having to change these dates, but it also allows people to plan ahead. And that’s good for the economy as well as the nation’s morale. As a result, the UK economy will rebound much more quickly than Europe, and England will outperform the rest of the UK. That’s good for sterling and means that the Bank of England’s quantitative easing programme probably won’t continue beyond November. That will put upward pressure on gilt yields.
Bond yields continue to rise but Japanese investors could provide some relief this week
Domestic influences do matter for UK equities and bonds, but international factors, especially the US, matter even more. Yields on 10-year US Treasuries have risen by 70 basis points so far this year. Much the same as our own gilt yields. But the level here remains much lower, half the US level. As I’ve said before, I expect yields on 10-year government bonds to go to 2% in the US, 1.5% in the UK and zero in Germany. There’s still a long way to go.
But there might be some relief this week. Japanese investors hold massive amounts of US bonds, both corporate and government. The end of this month is their financial year end and they usually sell chunks of their holdings in March before the year end, buying back futures later in the month. So nervous are the primary dealers given the rout in the market that they’ve suffered recently, that they are reluctant to hold the inventory to support this move. If I’m right, this would only mark temporary respite.
US inflation expectations – looking beyond the 10-year breakeven
One final point – inflation expectation in the US. You will have seen all the attention given to 10-year breakeven inflation moving sharply higher, pushing through 2% and hitting highs not seen since 2013. But the US Federal Reserve (Fed) focuses on the 5-year forward of the 5-year breakeven rate, and those numbers are lower and more stable so far this year.
Source: BMO Global Asset Management, as at 15 March 2021
The chart above shows the futures price of Brent oil currently and 6 months ago. All the headlines have been about the jump in the ‘spot’ (current) price of oil from 40 dollars per barrel 6 months ago before the vaccines news broke, to almost 70 dollars a barrel today. But current oil futures prices show a fall from these high oil prices over the coming years – prices for delivery in 2028. Why? Because extra supply from US shale will bring prices back down. So, if prices follow the futures curve, this will depress headline US inflation in future years. On this basis, the Fed can be relaxed, and so can we.
Central banks the ones to watch this week
We’ll see what the Chair of the Federal Reserve, and the Governor of the Bank of England, have to say this week. Markets will be watching closely, and although we are in for a bumpy ride, if we do see a setback in equity markets, it could be a buying opportunity.