Market Insights – 8th October 2018

US bond yields rose sharply over the week, with ten-year paper breaking through the range they had been moving in for several months. They ended the week at 3.22%, exceeding their recent high of 3.11%. The latest inflation fig-ures don’t seem to be behind this up-trend. They were actually quite reassur-ing for bond investors, as hourly wages did not pick up as much as expected in September: they gained 2.8% year on year, down slightly on the previous figure of 2.9%. We’re therefore far from levels needed to spark a major price hike. In previous macro cycles, wage increases reached 3.5–4.0% before they were considered a threat to price stability. Instead investors have become con-cerned that the Fed might ramp up its monetary tightening, since the chair was not so reassuring last week. It seems the Fed’s recent policy statement was inter-preted as being much more accommo-dative than Jerome Powell would have liked. He therefore made it clear that the Fed was not yet done with its rate hikes. His comments had an unequivocal im-pact on the bond market, with ten-year Treasuries dropping by more than 1%. The fear of inflation seems to have given way to fears of an overly abundant supply of US sovereign bonds, which will be needed to fund the Trump administration’s tax cuts and increase in infrastructure spending. We think these fears are overblown, as the US bond market is one of the only mar-kets in developed countries to offer positive real returns (i.e. returns that offset inflation). In a globalised financial world, investors will quickly regain inter-est in US bonds and may even move out of bond markets offering negative real returns. If long-term bond yields rise anywhere it will be in Europe and Japan, where they are still at rock bottom and well below the inflation forecasts for the next few years.

Since June, the Chinese authorities have unveiled a raft of measures to stabilise output by offsetting the impact of tariffs and improving the economy’s resistance to external shocks. They include devalu-ing the yuan, applying countercyclical measures, lowering reserve ratios and cutting income taxes.
Over the weekend, China’s central bank slashed reserve requirements for most Chinese banks by a further 100 basis points in an effort to counter last week’s disappointing manufacturing PMI fig-ures. This is the fourth cut this year, and it will inject around USD 100 billion into China’s banking system.
Even though shadow banking is on the decline, there has been a sharp increase in bank loans and bond issues by local governments and companies in recent months. These looser lending conditions are the first step in the government’s fiscal stimulus aimed at boosting infra-structure spending. For the time being, the Chinese authorities’ stimulus measures have been modest: they are staying cautious and want to make sure they have some room to manoeuvre in case the trade war drags on. That possi-bility cannot be ruled out, given the re-cent provocation by the USA.