FLASH NOTE
Flash Note
Sovereign Bonds Outlook 2017
Sovereign bond yields to rise as reflation takes hold
Pictet Wealth Management - Asset Allocation & Macro Research | 10 January 2017
• Inflation should accelerate in the
US, the Euro area, the UK and Japan
in 2017.
• Monetary policy should become less
accommodative, with the US
Federal Reserve hiking Fed funds
rates twice by a quarter point, the
Bank of England stopping its
quantitative easing, and the
European Central Bank and Bank of
Japan both announcing a tapering
of their own QE programmes for
2018.
• Fiscal policy could loosen
somewhat, thereby boosting
economic growth.
In such a reflationary environment,
10-year sovereign bond yields should
rise globally, except in Japan where
the BoJ will hold the Japanese
government bond (JGB) yield at 0%.
We forecast the following 10-year
sovereign bond yields: US Treasury,
3%; German Bund, 0.7%; UK gilt,
2%; and Japanese JGB, 0%.
AUTHOR
Lauréline CHATELAIN
[email protected]
+41 58 323 4581
Pictet Group
Route des Acacias 60
CH - 1211 Geneva 73
www.pictet.com
Our central scenario for developed markets (DM) sovereign bonds yields for
2017 is based on our in-house risk-factor analysis. This analysis leads us to
conclude that there is a 65% probability that 2017 will be a year of reflation
(see table below).
Underpinning the economic environment will be the following three
macroeconomic factors:
•
Inflation, which should accelerate in the US, the euro area, the UK
and Japan.
•
Monetary policy, which should become less accommodative, with the
US Federal Reserve (Fed) hiking Fed funds rates twice, the Bank of
England (BoE) stopping its quantitative easing (QE), and the
European Central Bank (ECB) and the Bank of Japan (BoJ)
announcing a tapering of their own QE programmes for 2018.
•
Fiscal policy, which may be loosened, especially in the US if Donald
Trump goes through with his fiscal plan in an effort to stimulate
economic growth.
In such a reflationary environment, interest rates become a market risk factor
of some importance, with 10-year sovereign bonds yields likely to rise
globally, except in Japan where the BoJ is committed to hold the Japanese 10year government bond (JGB) yield at 0%. We forecast that at the end of 2017
the 10-year sovereign bonds yields will be 3% for the US Treasury, 0.7% for
the German Bund, 2% for the UK Gilt and 0% for the Japanese JGB.
Due to the expected rise in sovereign bond yields, total returns from
benchmark government bonds may be negative in 2017. We do not expect the
safe-haven status of benchmark bonds to come under threat, with positive
total returns in case of market turmoil. But the insurance protection offered
by sovereign bonds in portfolios could become costly, which has rarely been
the case over the past 35 years, characterized by a bull market in DM
sovereign bonds. Moreover, a significant upward move in sovereign yields
could represent a start of a reversal of this 35-year bull market, meaning that
the momentum could change and lift yields closer in line with
’fundamentals’, (historically considered to be close to the issuing-country’s
nominal GDP growth).
Risk-factor analysis of sovereign bonds
MACRO RISK
FACTORS
US
EURO
UK
JAPAN
2017 central scenario (~65%) - Reflation
INFLATION
Core inflation
normalising (2%+)
but no overheating;
wages on check
Headline below target
in 2017-18, with
downside risks to core
(1.0-1.2%)
Large overshooting
(3%+) due to
imported inflation
Headline and core
rising, well below
target (0.3-0.5%)
MONETARY
POLICY
Gradual normalisation
(2 hikes in 2017)
Still supportive; QE
extended through
2017, taper in 2018
BoE close to ZLB (no
hike), creating fiscal
space
YCC challenged;
tapering possible in
H2 2017
FISCAL
POLICY
Fiscal stimulus ~1.0%
of GDP, kicking in H2
2017
Small and uneven
fiscal easing (~0.5%),
with upside risks
Targeted stimulus
amid long-term
consolidation trend
No major fiscal
expansion beyond
2016 budget plans
MARKET RISK
FACTORS
US Treasuries
Euro gov. bonds
UK Gilts
Japanese JGBs
INTEREST
RATE
10Y Treasury yield
reaching 3%
10Y Bund at 0.7%,
spreads widening in
Spain & Italy
10Y Gilt yield reaching
2%
10Y JGB yield stable at
0%
US Treasuries
Euro gov. bonds
UK Gilts
Japanese JGBs
QUALITY
Safe-haven status
conserved in turmoil
Safe-haven status for
Bunds, less so for
peripheral bonds
Safe-haven status
conserved in turmoil
Safe-haven status
conserved in turmoil
MOMENTUM
Regime shift due to
accelerating inflation
Regime shift due to
less QE in 2018
Regime shift due to
accelerating inflation
Regime shift due to
less QE in 2018
INVESTMENT RISK
FACTORS
Source: Pictet WM - AA&MR
The rise in US Treasury yields to continue
The election of Donald Trump as US president represents a potential gamechanger for US Treasuries, as the new president’s proposals for fiscal
spending could trigger an acceleration of US GDP growth from H2 2017
onwards (equivalent to around 1% of GDP in 2017-2018, starting in H2 2017)
and increase the net issuance of US Treasuries, which has been falling
massively since 2015. But before then, US GDP growth could weaken in H1
2017 due to recent US dollar appreciation and the rise in US Treasury yields,
which together have resulted in a tightening of monetary conditions. From an
average of 1.7% in H1, economic growth could accelerate to 2.4% in H2 2017,
when the fiscal boost should start to kick in. Prospects for a pick-up in
growth should enable the Fed to hike Fed funds rates twice by a quarter
point in 2017, thereby raising the 10-year TIPS yield from 0.4% to 0.8%.
Inflation should also move higher, with the headline PCE price index
reaching 2.4% (YoY) and core PCE 2.1% (above the Fed’s target), by the end
of 2017. Wage growth should accelerate moderately as the labour market
continues to tighten. The US 10-year inflation breakeven rate could move
from 1.9% to 2.2% by the end of 2017, in line with our forecast for a 10-year
nominal US Treasury yield moving from 2.4% to 3%.
ECB’s tapering announcement to push Bund yields higher
The ECB decision to prolong QE at the pace of EUR 60bn of asset purchases
per month from April to December 2017 ensures that buying pressure on
10 January 2017 | FLASH NOTE - Sovereign Bonds Outlook 2017 | PAGE 2
German government bonds will remain strong during much of 2017, with the
issue of tapering only emerging late in the year. However, the modification
of some technicalities, such as the extension of purchases to bonds with a
maturity above one year instead of two years and to bonds with yields below
the deposit rate, will reduce the pressure on the long-end of the German
sovereign yield curve. The average maturity of ECB’s German purchases will
drop, enabling the 10-year Bund yield to move upwards. Moreover, as 10year Bunds remain highly correlated with US Treasuries, and as we expect
the 10-year US Treasury yield to rise, the same should be true for the German
Bund yield.
Euro area growth could decelerate slightly to 1.3% in 2017, compared to 1.6%
expected in 2016. The anticipation that tapering will begin in 2018 combined
with economic growth should lead to a rise in the 10-year inflation-linked
Bund yield from -0.9% to -0.6%. Inflation in the euro area could accelerate
from 0.6% (YoY) in November to 1.4% by the end of 2017, according to our
estimates, and core CPI could rise to 1.3%, thereby moving the 10-year Bund
inflation breakeven closer to its long-term average of 1.4%. Hence, the 10year nominal German Bund yield should increase from 0.2% at the end of
2016 to 0.7% at the end of 2017.
Peripheral spreads to widen on ECB’s tapering talks
In the euro area periphery, Italy should remain in a weaker position than
Spain. Italian growth could continue to be subdued, at 0.7% in 2017
compared with 2.3% in Spain. Spain has a minority government that seems to
function, whereas Matteo Renzi’s resignation as prime minister will probably
trigger elections in Italy in Q2 2017. The outcome of those elections remains
uncertain as the opposition 5 Star Movement (5SM) and the governing
Democratic Party (PD) are neck and neck in opinion polls. The risk of the
5SM winning the elections and holding a referendum on Italy’s membership
of the euro area could continue to weigh on the performance of Italian
sovereign bonds. According to our analysis, Italian government bond spreads
could widen by 40bp in 2017 from an end-2016 level of 161bp over Bunds,
while Spanish spreads by 20bp from 118bp. All in all, the 10-year Italian
sovereign bond yield could rise from 1.8% to 2.7% and the Spanish
equivalent from 1.4% to 2%, as the ECB lays out it plans for tapering in
2018.
Decision not to extend QE will lead to higher Gilt yields
The significant depreciation of the British pound since the Brexit referendum
of June 2016 has led to an upward revision of inflation expectations for the
UK. Our economists expect headline inflation to peak at 3% (YoY) in 2017
and to finish the year at around 2.9%. Core inflation should also move
upwards to 1.9%, close to the BoE’s target of 2%. The 10-year inflation
breakeven yield should continue to move higher, reaching 3.4% in 2017 as
actual inflation picks up. Moreover, the risk remains that the UK is heading
for a ‘hard’ Brexit, involving the loss of unfettered access to the Single
Market. This would further hit the British pound and economic growth.
Furthermore, the rise in inflation should limit BoE’s ability to accommodate
further monetary policy (for example, by cutting the Bank Rate from 0.25% to
zero or expanding its QE programme). The BoE has announced that its asset
10 January 2017 | FLASH NOTE - Sovereign Bonds Outlook 2017 | PAGE 3
purchases would stop once it had bought the GBP60 bn of Gilts and the
GBP10 bn of investment-grade corporate bonds set out in its latest QE
programme last August. This means that QE should have run its course
during 2017 and will not be extended, thereby reducing the downside
pressure on the 10-year Gilt inflation-linked yield. According to our
estimates, it should rebound from -1.8% to -1.4% in 2017, with the nominal
yield rising from 1.4% to 2%.
BoJ holding the 10-year JGB yield at 0%
The announcement by the BoJ of a new policy measure called yield curve
control, which involves holding the 10-year yield at around 0%, means the
JGB has been capped at this level since September 2016. Even as long-term
sovereign bonds yields have increased in other developed markets, the 10year JGB yield has remained steady, limiting losses for investors. We believe
the BoJ’s new policy framework will remain in place in 2017 and until the
YoY increase in CPI (excluding fresh food) exceeds the BoJ’s target of 2%. But
since our economists expect CPI to rise only to 0.6% by the end of 2017, well
below the BoJ’s target, the BoJ will be obliged to keep defending 0% for the
10-year yield. Currently, the BoJ owns almost 40% of outstanding JGBs,
whereas overseas investors hold 10%. The potential for foreign investors to
test yield curve control could constitute the main risk for JGBs in 2017.
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We expect the 10-year JGB inflation breakeven yield to rise from 0.6%
towards 0.8% by the end of 2017 and the 10-year JGB inflation-linked yield
to fall from -0.6% towards -0.8%, as the BoJ increases its purchases at the
long-end of the curve to hold the 10-year nominal yield steady at 0%.
Main risks to the central scenario
In an alternative, more upbeat scenario (probability of 25% in our view), US
supply-side policies from the Trump administration, including a large fiscal
stimulus, could drive US GDP growth up to 3% in 2018. In this scenario,
positive momentum in the US would benefit other developed countries, with
GDP growth accelerating to 2% in the euro area and in the UK, and to 1% in
Japan, thanks to rising external demand. This increase in global growth
would lead to a stronger rise in DM government yields than we forecast in
our central scenario.
In a scenario more downbeat than our central one for 2017 (10% of
probability, in our view), an increase in protectionism in the US due to the
introduction of new trade tariffs combined with renewed US dollar
depreciation would lead to a rise of imported inflation without boosting
growth. This would lead to a stronger rise in US Treasury yields because
inflation would exceed the Fed’s target, forcing it to hike base rates faster
than we expect in our central scenario. However, fears of a recession would
lead to a flattening of the US sovereign yield curve, with the 10-year yield
rising less sharply than short-term ones. In this scenario, populist and eurosceptic parties would gain ground in European elections in 2017, stoking
growing fears of a break-up of the euro area. In addition, the prospect of a
‘hard’ Brexit could materialize, further hurting the British pound, pushing
DM government bonds yields even higher than we expect in our central
scenario.
10 January 2017 | FLASH NOTE - Sovereign Bonds Outlook 2017 | PAGE 4