Yield Outlook: Central banks gradually turning more hawkish

In the past few editions of Yield Outlook, we have argued that bond yields (represented by 10Y US Treasuries and German Bunds) are likely to range trade through 2017. This is still our view. However, over the past months, yields have moved to the low end of their ranges in both Europe and, not least, the US. The decline in yields should be viewed against the background of still low inflation and a certain repricing of the Federal Reserve, as well as the market focus on North Korea and the US debt ceiling, which has triggered safe-haven purchases.

We believe that the downward pressure on 10Y yields is gradually easing. Also, yields could begin to increase towards the top of the range in coming months and the risk of a more significant and abrupt rise in yields seems to have increased, in our view.

Improving global economy and lower geopolitical risks

The global economy seems to be in good condition, in our view. Global confidence indicators such as PMI indices are running at high levels and cyclical metal prices have increased after the summer holidays. True, inflationary pressures are low; but the fear of deflation has gone.

Also, global uncertainty has declined. While the conflict with North Korea has not at all been solved, it does not make the headlines the same way it did just a couple of months ago. The agreement to suspend the US debt ceiling until December has postponed a looming political crisis in the US. Furthermore, the costs in connection with Hurricane Irma look likely to be smaller than feared. The reduced global uncertainty could put a damper on safe-haven assets and, viewed in isolation, could push rates and yields up.

This movement could be further reinforced by the term premium currently being rather low. The term premium refers to the extra premium (now negative) that investors demand for buying a 10Y bond rather than 10 1Y bonds over the next 10 years. In other words, investors receive no additional payment for buying, for example, a 10Y compared to 10 1Y bonds. In the US, the 10Y term premium is in fact as low as minus 0.42%. If this premium normalises, we should expect nominal yields to increase – all else being equal.

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