The recent spike in market volatility has pushed government bond yields in developed markets (DM) further down. The trend of falling bond yields has been in place since June.
Inflation expectations have declined in line with the oil price
Risk aversion leads to falling government bond yields
Initially volatility in yields increased due to the worries about Greece, but from the second half of July the focus of investors shifted away from Greece. Yields then started to decline on the back of weak Chinese economic data and the sharp declines in Chinese equity markets and commodity prices. The surprise devaluation of the Chinese yuan and increased emerging market (EM) uncertainty further enhanced the fall.
The trend of declining bond yields applies to the US, Germany and the UK and to a lesser degree to Japan as well. The drop in yields was especially pronounced in countries where a near-term start of the interest rate hiking cycle was expected, namely the US and the UK.
Inflation expectations fall in line with the oil price
A key channel through which EM turmoil is impacting DM government bond yields is through inflation expectations. EM weakness has materialized in declining commodity prices, a development to which inflation expectations have been responding strongly over the past year. For instance, US and Euro 5y5y forward inflation expectations have a correlation of 97% with the Brent oil price since the beginning of 2014. The graph on the right shows how inflation expectations have behaved over the past months. Since the end of June, both Eurozone and US 5y5y forward inflation expectations have started to fall again, in line with the oil price.
Real yields keep trending up
If the market were worried about the overall outlook for global economic growth and monetary policy, the real yield (the nominal bond yield minus inflation) would also decline. This is however not the case at the moment. In fact, there is still a slight upward trend in real yields in both the US and the Eurozone. Over the past week, the real US yield was actually up. Whether this trend continues will depend on whether there will be significant spill-over from the EM crisis into the DM growth environment.
In the meantime, the sizeable drop in the inflation expectations component of nominal bond yields more than compensates for the mild upward trend in real yields. For this to stop, we need to see a stabilization of the oil price, given the high correlation between the oil price and bond market implied long-term inflation expectations.
Fall in oil price affects high yield and EMD
In other fixed income markets, a stabilisation of the oil price would be welcome too. Falling oil prices are putting pressure on high yield bonds and emerging market debt (EMD). In both markets, spreads rose to the highest level of this year last week.
For high yield, this is perfectly understandable given the weight of the oil sector in the high yield universe. At current oil prices, the default risk is moving higher. According to Fitch, the 12-month trailing default rate in the US energy sector could jump from 1.9% on average towards 4%. In the US metal sector, the default rate is already at 10% and could jump towards 15%. Fortunately, outside these sectors the default rates remain low. Similarly, the drop in the oil price puts pressure on the government finances of oil producing countries and therefore on EMD.
The silver lining is of course the beneficial impact of lower energy prices on consumer spending power.
Unclear to what extent global growth will be affected
With regard to the possible contagion from EM space to DM space and global economic growth, a lot will depend on how much further the self-fulfilling dynamics in EM space will run. First of all, labour markets have started to weaken after years in which the unemployment rate continued to decline despite slowing growth. This suggests that EM corporates now expect the sluggishness in demand to be more severe or to last longer than before. There is a distinct self-fulfilling element here because this will cause a decrease in household income growth and confidence. Secondly, the Chinese devaluation has also caused a still unknown shift in expected future exchange rate levels in many other EM economies. This has set in motion a self-fulfilling detrimental dynamic in EM financial conditions. To the extent that EM policymakers have a low degree of credibility, they may have no other option but to tighten domestic monetary policy to tame depreciation expectations.
Potential triggers to curb these self-fulfilling dynamics include an increased willingness by EM policymakers to implement reform. In addition to this, the perception that EM will receive external support via robust DM demand and the expectation of continued easy global liquidity conditions could also cause the pace of EM adjustment to slow down.
Global liquidity conditions remain supportive
We expect a more shallow hiking cycle by the Federal Reserve and also foresee more easing by the Bank of Japan (BoJ), with an increased probability that the ECB will do the same. This should keep global liquidity conditions on an easier path than foreseen before the summer. In itself this should act as a force which limits EM net capital outflows.
The July statement of the Federal Open Market Committee (FOMC) made it clear that the Fed feels it is close to meeting its employment objective as it now only needs to see “some further improvement in the labour market”. However, the Fed is still undecided on the criterion for meeting the inflation objective which is “reasonable confidence” that the target will be attained in the medium term.
We expect the financial market turmoil on the back of the Chinese devaluation to prevent the Fed from hiking in September. However, a rate hike later this year, most likely in December, is still on the cards provided global risk appetite returns to some extent. We have also lowered our forecast for the Fed Funds rate at the end of 2016 to 1.25%. The reason is that EM adjustment and the anticipation of more easing by the BoJ and/or ECB could put upward pressure on the dollar.