12 August 2021
Path to normalisation
We explore how central banks are carving out the path to normalisation, including the underlying drivers and what normalisation could mean for yields in the medium term.
Recent economic data prints across developed economies suggest a constructive macro outlook despite Delta variant concerns. In the US, non-farm payrolls data released on 6 August 2021 came in at 943,000, well above economists’ expectations and the consensus estimate of 870,000. This was the largest increase since last August and coincided with a 0.5% decrease in the unemployment rate to 5.4%, which is now at the lowest level since the beginning of the pandemic. This print confirmed that the labour market recovery is on track to reach the Federal Reserve (Fed)’s “substantial progress” target. As such, a growing number of Fed speakers are turning more hawkish as confidence in the economic outlook grows, and we view the September Federal Open Market Committee (FOMC) as a likely date to introduce and formalise tapering to begin in early 2022 and start rate hikes in the second half of 2023. The UK labour market is also showing signs of healing from the pandemic, as furlough schemes are wound down and restrictions lifted. Indeed, the Bank of England (BoE) shifted the guidance around its exit strategy last week, beginning with a balance sheet runoff when policy rates reach 0.5% from the current 0.1%, and potentially active Gilts sales when rates reach 1%. Similarly, the Reserve Bank of Australia (RBA) published a more bullish set of economic forecasts and, despite low vaccination rates and renewed Covid outbreaks, the RBA remains on track to taper bond purchases in September.
Across developed economies, central bank rate hikes are priced in over the medium term
While US Treasuries rallied over the month of July, yields appear to have overshot to the downside. So far, we have seen a reversal in August as yields have risen by 10 bps and currently sit at 1.34% (as of 11 August). Core government bond yields over the past week in the UK, Canada and Australia have traced similar moves. In Europe, however, core and peripheral yields have been muted, if not falling, over the month as the European Central Bank (ECB) signalled a notably dovish change to forward guidance, with no rate hikes until inflation reaches 2%. With the exception of Europe, central bank rate hikes are increasingly priced in across developed market economies and, as such, we believe the path of least resistance is a slow drift higher in yields over the remaining months of the year.
The technical backdrop should act as a catalyst for higher yields over the coming months. While US government bond supply has currently subsided in the usual seasonal slowdown, we anticipate a reversal of this trend with further issuance (net of Fed purchases) from September and the expected outline of a commencement of tapering in Q1 2022. In turn, we anticipate investor positioning to move more bearish on duration. Similarly, the BoE’s exit sequencing reversal announcement favours expectations of increased net supply into the end of this year. As other central banks commence policy normalisation (the Bank of Canada is expected to announce the final two purchase reductions this year and a rate hike in July 2022), changes in supply/demand balances should push yields higher.
What does this mean for fixed income investors?
While developed market central banks remain, for the most part, slow to move off the zero lower bound, they are eager to start carving out a path to normalisation. As we discussed last week, the post-peak global growth environment appears robust. Although tail risks for economies exist, such as new virus variants, we expect central banks will confirm, if not strengthen, their hawkish guidance. This means as output and labour market gaps slowly close, yields should converge to higher levels.
About the Bond Bulletin
Each week J.P. Morgan Asset Management's Global Fixed Income, Currency and Commodities group reviews key issues for bond investors through the lens of its common Fundamental, Quantitative Valuation and Technical (FQT) research framework.
Our common research language based on Fundamental, Quantitative Valuation and Technical analysis provides a framework for comparing research across fixed income sectors and allows for the global integration of investment ideas.
Fundamental factors include macroeconomic data (such as growth and inflation) as well as corporate health figures (such as default rates, earnings and leverage metrics)
Quantitative valuations is a measure of the extent to which a sector or security is rich or cheap (on both an absolute basis as well as versus history and relative to other sectors)
Technical factors are primarily supply and demand dynamics (issuance and flows), as well as investor positioning and momentum