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The final hours of 2016 are upon us – and given the event risk that has come and gone this year, I am sure there are still a number of people out there still expecting the wheels to fall off the seemingly unstoppable “Post Trump Hard Brexit” bus only for all to be revealed as nothing more than the worlds biggest fake news story… Well, anything is possible – and at the time of writing, there are still a few hours left in the year 2016. So let’s take a few minutes to recap how we got here.
For the last few years central bankers around the world have been desperate for inflation. And despite all the tricks, potions and spells tried there has been little if any significant uptick. The hangovers from 2008 had left many fearful of long periods of deflation and low interest rates.
However 2016 has signalled that maybe a change is in the air. Over a period of five years, and mostly due to drops in the price of Crude Oil (and steel), the Reuters CRB index has declined 58% from the highs of 370 in 2011 before finding a base of 155 earlier this year.
And so it is argued that this period of oversupply in the commodity sector is finally coming to a head. Falling prices are now themselves falling out of the inflation numbers. This transition started to manifest itself at the turn of the year, just before commodity prices formed a base in the first part of 2016.
Rising debt levels and a bond market rally fuelled by central banks determined to keep interest rates low are “so 2015”. The election of Donald Trump as the next US President in November could turn out to be the trigger to the gun aimed at the bond bull. And I must say, this doesn’t feel like a false dawn. This time when we say goodbye to low interest rates, it could be for a very long time.
And so somewhat similar to Dr Frankenstein looking over his monster, and screaming “It lives!”, we cheer the fledgling spurts of inflation. In China, producer prices moved sharply into positive territory for the first time in over 5 years, while inflation in the US, EU and the UK has been trending higher through 2016 – in the case of the UK, predominantly due to the drop in cable following that little Brexit matter.
The prospect of higher inflation quickly manifested itself in the bond market. Simply put, yields rose, and prices fell. Following Brexit and a pre-emptive rate cut, yields on UK Gilts continued to rise from 0.5%, eventually reaching a 6 month high of 1.5%. The decline of the pound against its currency peers can only spell inflation, raising the question of whether or not Mark Carney and the BOE were too quick to cut rates post Brexit? State side, and although still only President Elect, the Trump effect on US Treasuries belies the fact we still don’t know what his plans are. However the expectation of a fiscally stimulating, tax cutting, factory building and trade-organisation-leaving presidency seemed to be enough to cause some major moves in the bond market at the tail end of 2016.
Yields on the US 10 Year treasury Note have risen from lows of 1.36% after the Brexit Referendum, to reach a high for the year of 2.59% in December, with the biggest move coming after the election of Donald Trump.
So where will yields go in 2017? If the below chart is anything to go by – the only way is up. This view works in line with the fundamental assumption that President Elect Trump follows through on his pledges of fiscal stimulus and his somewhat isolationist approach. Let’s not also forget the potential for tapering of the ECBs bond purchasing program, and suddenly 2017 seems very bearish for bond prices. In these circumstances, it’s unreasonable to expect yields to start tapping on the ceiling of 3% soon into 2017.
Chart Source: tradingview.com