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Are we finally seeing a great rotation out of bonds?

18 November 2016

Are we finally seeing a great rotation out of bonds?

Since President-elect Trump’s victory we have seen a selloff in bonds across the globe. Many people have been predicting a reversal for bond markets after years of falling interest rates. Could this be the start of a much bigger move or a short term correction?

Bond markets are driven by interest rate expectations and supply and demand. With many central banks targeting inflation, the path of interest rates is dependent on long- term inflation expectations. I stress ‘long-term’ because they generally look two years forward and have frequently ignored short-term deviations from target.

The Bank of England (BoE) has a 2% target for Consumer Price Inflation (CPI). If it deviates more than 1% from the target, the Governor of the BoE has to write to the Chancellor to explain what is happening. In the last two years he has written several letters to explain why CPI has undershot the target range. Post Brexit, prices have started to rise due to the depreciation of sterling. This time last year, oil prices were falling but they bottomed in January and have been rising since then. Importers often buy currency forward and fashion items in Autumn and Winter collections will have been ordered before the currency fell. This hedging activity and a squeeze on retail margins may delay the impact of currency falls.

This week we had the latest UK CPI numbers and at 0.9%, they were less than predicted, however we do still expect inflation to be above the target rate in the first half of next year. This was to be expected, as per the BoE quarterly inflation report, and there is also talk of the inflation rate falling back to target in the years to come. Currency effects are short term unless we see a continued slide in the pound. As a result, at this time we do not believe the Monetary Policy Committee will raise rates in response.

Globalisation has kept prices low as manufacturing was able to move to the cheapest parts of the world. Trump’s indicated trade policy would be a retreat from this and would involve raising tariffs on imports. If the UK fails to make a good post Brexit deal on trade with Europe a similar effect will be felt here. Again, these are potentially one off effects but do remain a concern.

Another concern for markets is the influence on prices, supply and demand. Donald Trump, in his acceptance speech, only mentioned one real policy and that was to increase infrastructure spending, which would imply more government borrowing. At the conservative party conference there was talk of a relaxation of the previous Chancellor’s austerity measures, which could mean more supply in the Gilt market. The Autumn Statement next week will give us an indication of how much the new Chancellor can do. As for Trump, we will see how much US Congress will let him do in the months to come.

In many ways there are still deflationary forces at work. Globalisation cannot be entirely reversed and internet price checks, automated production and an ageing population all mean that, in my view, we are not in for a long-term higher inflation rate. Given the amount of gearing in the global economy, in both government and private sectors, any rise in interest rates will be a further constraint. Thus we believe that official rates will only rise very slowly in the UK and US despite short-term inflation threats. However bond markets may remain volatile as fears come and go.


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