A core element of our outlook is the gradual “pivot” in Central Bank policy that will lead to higher yields in many government bond markets, including Australia.
All three of the major developed world central banks have been buying substantial volumes of long dated government bonds in their jurisdiction (see chart) and this is drawing to a close. The recovery in developed world economies is now sufficiently progressed to allow this.
Moreover, the counterproductive side effects of the European Central Bank (ECB) and Bank of Japan implementation of Quantitative Easing (QE), resulting in extremely low long dated bond yields, is now outweighing the benefits.
Chart Source: Bloomberg
The US is the most advanced of the developed world economies in both its recovery, and normalisation of monetary policy. The Fed stopped its asset purchase program three years ago and we expect it to announce further reductions to its balance sheet in September - which will be implemented over the next 12 months. Initially its balance sheet will be reduced by $10 billion per month ($6 billion US Treasuries, $4 billion mortgage backed securities) rising proportionally each quarter for a 12 month period until it reaches $50 billion.Europe
It will be difficult for long dated US bond yields to rise, without European rates moving higher. We do not expect the ECB to lift cash rates, therefore limiting the quantum of US cash rate hikes. We also expect to see a reduction in ECB bond purchases that will allow long dated European rates to lift, and consequently US Treasury yields to rise.
In a landmark speech in late June ECB President, Mario Draghi, we believe laid the ground work for the ECB to announce a plan to reduce the amount of European Government Bonds it will purchase each month.
"As the economy continues to recover, a constant policy stance will become more accommodative, and the central bank can accompany the recovery by adjusting the parameters of its policy instruments – not in order to tighten the policy stance, but to keep it broadly unchanged."
Mario Draghi European Central Bank Forum in Sintra, Portugal, 27 June 2017
The Bank of Japan’s target for purchasing ¥80 trillion Japanese Government Bonds (JGBs) per year became redundant when it decided to lift the yield on 10 year JGBs by targeting 0%. It’s impossible to expect the BOJ to target both the quantity of JGBs it buys and the price of the JGBs at the same time. Since February 2017, the BoJ’s purchases of JGBs decreased from an annual rate near ¥80 trillion to ¥70 trillion whilst JGB purchases has been sufficient to keep the yield on the 10 year JGB near its 0% target - tapering QE.
Surprisingly, central bank commentary has been articulated despite recent falls in headline inflation. Draghi has recently described the fall in oil prices impact on inflation as “temporary”. And at the recent Federal Open Market Committee press conference, Chair Yellen was dismissive of the last three consecutive low monthly core inflation prints saying slow price rises were attributed to “one-off reductions in certain categories”, and that “it’s important not to react to a few readings.” Draghi and Yellen are both being careful not to adversely affect inflation expectations, whilst acknowledging headline inflation has fallen.
Should low inflation prove to be more persistent, this may slow the pivot, and the rate at which longer dated bonds may rise. But it appears all major central banks recognise the benefits to savers, consumers and the banking and business sectors of having higher yielding long dated assets, even if it means keeping short dated borrowing costs close to zero for some time to come.
This chart highlights the bond yields before and during QE of three major economies in Europe and America. With the unwinding of QE in these economies, bond curves will more closely resemble their pre-QE shape. The hard lines are pre-QE curves, compared with dotted lines representing curves during QE.
Chart Source: Bloomberg