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.

Federal Reserve meeting

Everything you need to know about the Federal Reserve’s FOMC announcement – including when it is, and why it’s important.

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.

IGA, may distribute information/research produced by its respective foreign marketing partners within the IG Group of companies pursuant to an arrangement under Regulation 32C of the Financial Advisers Regulations. Where the research is distributed in Singapore to a person who is not an Accredited Investor, Expert Investor or an Institutional Investor, IGA accepts legal responsibility for the contents of the report to such persons only to the extent required by law. Singapore recipients should contact IGA at 6390 5118 for matters arising from, or in connection with the information distributed.

This information/research prepared by IGA or IG Group is intended for general circulation. It does not take into account the specific investment objectives, financial situation or particular needs of any particular person. You should take into account your specific investment objectives, financial situation or particular needs before making a commitment to trade, including seeking advice from an independent financial adviser regarding the suitability of the investment, under a separate engagement, as you deem fit. No representation or warranty is given as to the accuracy or completeness of this information. Consequently any person acting on it does so entirely at their own risk. In addition to the disclaimer above, the information does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. Any views and opinions expressed may be changed without an update.

See important Research Disclaimer.

Find articles by writer