A sell-off in 10-year US Treasuries – weekly update 8 January

A look back over macroeconomic and market events for the week ending 12 January 2018. Bonds sold off on the back of perceived policy loosening from the Bank of Japan and rumours of a potential shift in Chinese reserves policy. Elsewhere, economic data remain positive, prompting the European Central Bank to start thinking about its messaging. The week ahead is fairly quiet, though the Chinese data batch release on Thursday could be interesting.

US Treasury sell-off pushes yields higher

A rhetorical sell-off in 10-year US Treasury bonds continued this week, pushing the yield above 2.5%. Much of this move was put down to actions by the Bank of Japan (BoJ) and comments from China, though it’s difficult to fully resolve specific causes against what has been a busy backdrop.

On Tuesday, data released by the BoJ showed a slight reduction of the Central bank’s asset purchase programme, which investors took as a sign that Japan was joining other major Central banks in beginning the process of withdrawing ultra-loose monetary policy. In reality, we think it is far too early to call. The BoJ’s asset purchase programme of Qualitative & Quantitative Easing is more nuanced than peers’ programmes and is aimed primarily at yield curve control, and the yield on the 10-year bond is comfortably within the target range. We will watch developments here closely.

Adding more fuel to the fire was a report circulating that China was considering cutting back on its purchase of US Treasuries, widely interpreted as further posturing amid US-China trade tensions. Shortly after, Chinese authorities dismissed the story as “fake news” which was to be expected.

Regardless of the cause, there is little denying that long rates in the US (and elsewhere, for that matter) appear to be suppressed as a result of global quantitative easing programmes, and we believe they remain vulnerable as global monetary policies begin to normalise.

Good news for the Eurozone

The Eurozone had a good news week, as reported Industrial Production growth for November remained at 3.2% year on year (yoy), down from the upwardly-revised 3.9% seen in October but slightly ahead of the 3.1% expected and a strong reading in its own right.

Retail Sales bounced back to 2.8% yoy (from 0.2%, and ahead of the 2.4% expected) and unemployment slipped 0.1% to 8.7%. With these positive data, it is little surprise that business optimism was also buoyant – the Business Climate Indicator rose from 1.49 to 1.66 (1.50 was expected) and the Economic Confidence measure rose from 114.6 to 116.0 (114.8 was expected).

All of this positivity was enough to prompt discussions at the European Central Bank (ECB) which, as revealed in the latest meeting notes, has started preparing the ground for a shift in the forward guidance – effectively forward guidance on forward guidance. There was also something of a breakthrough in German politics, with the reaching of an early-stage agreement that could pave the way to the formation of a coalition government.

US inflation remains robust

Although the headline CPI (Consumer Price Index) rate of US inflation slipped 0.1% to 2.1% yoy as expected, the Core CPI measure, which strips out food and energy and is a better barometer or core economic activity, surprised on the upside with a 0.1% increase to 1.8% yoy (against forecasts for no change). This was partly driven by auto demand post-hurricanes, but shelter inflation was also strong.

Retail sales slipped more than expected in December, to 0.4% month on month (mom). 0.5% was expected, but this release came with upward revisions to the previous reports suggesting a strong end to the year. Excluding autos, Retail Sales actually beat expectations, at 0.4% mom (0.3% was expected) from an upwardly revised 1.3%.

Last week’s other events

• The UK saw like-for-like sales growth unchanged at 0.6% yoy, beating forecasts for a fall to 0.3%. November Industrial Production cooled from an upwardly revised 4.3% to a still-solid 2.5% (1.8% was expected)
• Japan’s Consumer Confidence slipped from 44.9 to 44.7 (45.0 was expected). The Leading Index rose from 106.5 to 108.6, in line with expectations, but the Eco Watchers Outlook survey fell more than expected from 53.8 to 52.7 (53.5 was expected)

What does this mean for our investment strategy?

The recent hints of change at the ECB and the BoJ have significant implications for bond investors as we confront the inflection point of extraordinary monetary policy. In recent years, the risk of a sustained rise in bond yields has been ameliorated by low or falling commodity prices and an excess of global manufacturing capacity and labour. These conditions are not so prevalent today as we confront rising oil prices, higher utilisation rates and lower unemployment.

The conclusions of the 19th Plenum of the Communist Party in China were largely dismissed as immaterial but have important implications for inflation and bonds. A critical contributor to the global deflationary trend, China is now shifting the incentives away from growth at any cost to a more balanced economy, potentially reducing excess capacity and “normalising” global inflation.

The consequences for bonds are clear and the potential impact for equities is that investors will increasingly favour late-cycle value over expensive growth stocks. Traditional value managers have underperformed the markets in recent years and should return to favour if the environment we envision plays out.

The markets

It was a tough week for bonds, especially longer dated issues. Equities were steady whilst the commodity complex continued to see strength, especially in gold and oil.

Equities

Another reasonable week for equities, with the S&P 500 in the US rising 1.6% on the week. In the UK, the MSCI United Kingdom rose 0.6% and, across the Channel the MSCI Europe ex-UK index rose 0.3%. The TOPIX was the only major market to register a loss, as the Japanese index slipped -0.2%. The MSCI Emerging Markets index returned 0.6%.

Bonds

US 10-year Treasury yields were in the news as they pushed higher on the week, closing 7 basis points (bps) higher and breaking through the 2.5% mark to finish the week at 2.55%. UK 10-year gilts also moved higher, rising 10 bps on the week to finish at 1.34% whilst the equivalent German bund yields were 14 bps higher to finish at 0.58%.

Commodities

Gold continued to see inflows, helping push the price up to US$1,337.64 per ounce on Friday, whilst Brent Crude finished at US$69.87 per barrel, having briefly moved through the US$70 mark intraday on Thursday. Copper was fractionally softer at US$3.22 per lb.

Currencies

The US dollar was weaker on the week, whilst the yen gained strength on the back of the perceived shift in monetary policy. Sterling finished the week at US$1.37, €1.13 and ¥152.

The week ahead

A few more data points are out this week, but it’s fairly subdued overall. On Tuesday morning the UK reports CPI inflation which is expected to have slipped by 0.1% to 3.0%, with core inflation also expected down 0.1% to 2.6%. Wednesday gives us US Industrial Production (expected at 0.4% from 0.2% mom) and Capacity Utilisation. On Thursday morning, China produces its regular batch of data, including the first estimate of fourth-quarter GDP (6.7% yoy expected from 6.8%) together with Retail Sales, Industrial Production and Fixed Asset Investment. On Friday we’ll be looking out for UK Retail Sales figures, where a full 1.0% increase to 2.6% yoy is expected. Friday is also the deadline for the US to avoid another government shutdown. The daily breakdown is as followings:

Monday: A quiet start to the week, with the US on holiday. Japanese Machine Orders and PPI data as well as UK house price growth from Rightmove are the main releases.

Tuesday: As well as the UK inflation data, the US will release the latest Empire Manufacturing data and then Japanese Core Machine Orders are out in the evening.

Wednesday: Ahead of the US industrial production numbers, Eurozone Construction Output figures are released, but it is otherwise a quiet day.

Thursday: Overnight the latest batch of Chinese data will be closely watched. As well as fourth-quarter GDP, Retails Sales are expected to be unchanged at 10.2% yoy. Industrial Production is also forecast to remain at 6.1% yoy whilst Fixed Asset Investment is expected to have cooled by 0.1% to 7.1% year-to-date yoy. In the afternoon, the US will update the Philadelphia Fed Business Outlook, Housing Starts and Building Permits.

Friday: It’s a fairly quiet end to a quiet week. As well as UK Retail Sales, the University of Michigan reports on Sentiment and Inflation expectations.