What to expect from bond markets in 2018

David Absolon, Investment Director at Heartwood Investment Management

  • Reflation sets the tone for the bond markets in 2018. US tax cuts have shifted the market narrative and represent a large fiscal boost to the US economy, albeit temporary. They will significantly add to the US government debt burden, coming at a time when the US domestic growth is already benefiting from near full employment and rising capital expenditure.

  • Cyclical inflation pressures are rising with or without US tax cuts. Higher oil prices are expected to have an inflationary impact on headline measures, as well as the feed through from the likely higher import costs arising from a weaker US dollar. More important, though, will be the culmination of several months of strengthening global momentum feeding into prices across developed economies. In our view, inflation is a lagged response to growth since stronger demand should translate into higher spending and, ultimately, higher prices. Admittedly wage growth has been disappointing so far, but we expect that tighter labour market conditions will eventually feed into higher wage setting. Furthermore, the recently approved tax legislation has incentivised companies to use their tax windfall to boost wages and/or distribute bonuses.

  • The nature of the current extended cycle of low interest rates and low inflation is changing. As we enter a more ‘normal’ cycle, we expect central banks in developed economies to stay on a journey of withdrawing emergency levels of monetary stimulus and lifting interest rates. While the US Federal Reserve is ahead of other central banks, it is worth noting that despite five interest rate rises since beginning its tightening cycle in December 2015, financial conditions in the US have actually eased over the last year {Source: Chicago Fed National Financial Conditions Index}. There is still some way to go, especially if inflation rises as we anticipate.

  • The US treasury market’s vulnerability to supply and demand pressures is increasing. US treasury selling in early January was, in part, prompted by media reports that the Chinese authorities may reduce its buying of US treasuries. While these reports have since been denied, the US treasury market’s reaction is nonetheless indicative of its sensitivity to supply factors. And it is all the more noticeable in an environment where we are seeing a regime shift among global central banks from quantitative easing to quantitative tapering. Reduced global market liquidity is likely to receive more market attention as the year progresses. With the Fed is already reducing its balance sheet, the European Central Bank will end its asset purchase programme in September. Furthermore, the Bank of Japan has already announced that it will reduce longer-dated Japanese government bond purchases.

  • As central banks step back from supporting financial markets, we expect to see more bond market volatility in 2018. Shorter-dated US treasury yields had already moved meaningfully in the final quarter of 2017, but longer-dated bonds were still fixated to the low interest rate and low inflation backdrop. Evidently this view is now shifting, and we believe that our long-standing underweight duration position in developed sovereign markets remains the most prudent stance.