Bond yields were rising sharply in October and November last year but have mostly fallen a little since mid-December. There is a possibility that bond yields could continue to track lower, effectively a resumption of the world of disinflationary pressure and interest rates pushing lower for longer, but it seems to us to be a small possibility. More likely, bond yields will start rising again before long reflecting better global economic growth, a flicker of life in inflation, and a change already underway in economic policies around the world with more emphasis on fiscal expansion rather than monetary expansion alone.
The United States is a key sub-set of this changing world, exhibiting markedly better GDP growth as 2016 turned to 2017 than was the case when 2015 turned to 2016. Another year of strong labour market improvement in the US has seen average hourly earnings growth accelerate to 2.9% y-o-y in December 2016, the highest point so far for this long economic recovery and on the boundary of territory which in the past has seen wages growth support accelerating inflation. Already, underlying annual inflation is around the Fed’s target of 2% y-o-y and is threatening to push higher. The Fed has started to talk about the US economy approaching capacity adding much more credibility to the Fed’s indication of three Fed rate hikes in 2017 than the four rate hikes promised in late 2015 for 2016 that turned out to be only one in practice.
Apart from much firmer US growth, signs that the economy is approaching capacity and signs of accelerating inflation, the other big change in the US threatening to push interest rates higher is the policy plans of President-Elect Trump. Ahead of the Inauguration ceremony on Friday, financial markets have temporarily paused their bet that the Trump Administration will likely add more upward pressure on US growth and inflation through fiscal expansion (lower taxes and more government spending). That pause may not last long before Trump as President reaffirms his intention to cut taxes and spend more.
Outside the US, other key changes through 2016 that speak of higher bond yields in 2017 are the marked lift in global commodity prices, including energy prices, that have turned producer prices almost everywhere from exhibiting annual falls at the beginning of 2016 to showing mostly modest annual increases by the end of the year. One of the more dramatic changes in producer prices over the past year has occurred in the world’s biggest manufacturing economy, China. In December 2015 China’s producer prices were falling by 5.9% y-o-y but by December 2016 they were rising by 5.5%. The impact of higher factory gate prices in China has been muted for overseas buyers of Chinese manufactured goods by the depreciation of China’s currency, but that offsetting influence has part-reversed recently.
Disinflationary pressure at times moving to outright deflation in the likes of Europe and Japan has dominated while the world struggled to reduce excess economic capacity that built up after the global financial crisis. After nearly ten years excess capacity has reduced, almost entirely in the US, and even in Europe where the unemployment rate has fallen the best part of a percentage point over the past year to 9.8%. Those countries experiencing deflation at times early in 2016 have mostly returned to experiencing modest inflation. In Europe, headline inflation is 1.1% y-o-y for the most recent December 2016 reading.
While there is nothing pointing to inflation returning very strongly, it is fair to say modest rates of annual inflation are showing signs of creeping higher. Meanwhile, global bond yields, even after the push higher in the later months of last year are still hardly reflecting the improvement in global growth over the past year and beginnings of a lift in inflation, let alone if President-Elect Trump really does deliver significant fiscal expansion at the same time effectively going to war with the Fed determined to stem adverse inflationary consequences.
The US 10-year bond yield has pushed down by 20bps over the past month to 2.40% and is only 35bps above where it was a year ago. The Australian 10-year bond yield at 2.70% is down by 15bps over the past month but is almost unchanged from where it stood a year ago. Given the economic changes over the past year all now pointing to higher interest rates over time it is very likely in our view that bond yields will start to rise again before long and possibly quite sharply. We see Australian and US 10-year bond yields pushing above 3% over the next month or two.