Low volatility is a thing of the past

Marc Ostwald, of ADM Investor Services, says markets are nervous about inflation, and if the yield on ten-year Treasuries neared 3.5% that could be an inflection point for equities.

The economic fundamentals in the United States are strong. Growth is steady, the labour market is near full employment, consumer spending is on an uptrend and confidence is robust. Not only does the picture look rosy in the United States, but there is a synchronized upswing in economic growth around the world. At Davos, the International Monetary Fund (IMF) lifted its forecasts for global growth by 0.2 percentage points to 3.9% this year and next.

Normally, the unwanted byproduct of this solid backdrop, according to economic theory, is inflation. Higher employment means more bargaining power for workers, pushing up wages and prices. However, 2017 was categorized by good growth and low inflation, creating the perfect conditions for equities. In the Treasury market, the curve flattened in 2017. Firstly, because low inflation expectations kept long-end yields subdued. Secondly, because short-end yields moved higher on increased Federal Reserve (Fed) rate hike expectations. Marc Ostwald, global strategist at ADM Investor Services International, said the so-called ‘bear flattener’ trade (buying the long-end and selling the short-end) was vogueish in 2017.

This month, markets became nervous that inflation was finally making a comeback. It began with the monthly non-farm payrolls (NFP) report, where average hourly earnings were much stronger than expected, sparking inflation concerns. That catalysed the sell-off in equities, and a jump in volatility. Ostwald said the sharp gyrations taught us that low volatility is probably a thing of the past. Worries about price levels intensified after US consumer prices rose by more than analysts’ estimates in January. That sent the yield on the ten-year US Treasury to the highest level in four years, above 2.9%. Ostwald says that while he does not expect to see a massive boost to inflation, the market is reassessing its inflation expectations. He says the US Treasury ten-year yield could get up to 3% very soon but it will be ‘a real push’ to get the yield up to 4%.

Ostwald says we have come to the end of the 30-year bull market for bonds but equally he says, that does not necessarily mean a massive melt-up for bond yields. He says there are other forces at work, such as demographics. His logic goes, as people save more there is a greater desperation for opportunities, and as yields move higher investors will buy the dips in bonds, sending bond prices up and yields down again.

In terms of the rotation trade, Ostwald says that if two-year yields rise to 2.5%, we could see some flows steer away from equities into bonds. On the ten-year yield, 3.3%-3.5% is the range which starts to potentially put downward pressure on the equity market.

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