It seems like the bull run in the bond market might finally be over which we feel is long overdue. Despite the US Fed having raised rates five times since late 2015, the bond yields remained low, supported by the low global inflation. We expect the combination of strong growth and low inflation to continue in 2018, and will now add pressure on bond yields. Hence, it allows us to set our macro view, leaning towards a reflationary environment driven by a global trade boom, higher commodity prices and US fiscal reflation. All these support a further tightening of the monetary policy which means higher yields. While the global economy is anticipated to continue its growth path in 2018 with central banks set to normalise their monetary policies, room for volatility in the near term is fairly glaring, including the Malaysian bond yields emanating from asymmetry or unanticipated shocks. Hence, investors will need to look beyond beta to meet their return requirements. It is becoming imperative to yield higher returns from fixed income portfolios via asset allocation or security selection, while managing the risks ahead. Looking at the bond yields outlook for 2018, we expect a big jump of 55 to 60bps for the yields of developed countries from the beginning of the year for the US 10-year Treasury to 3.00%, German 10-year yields to 1.00% and the Japanese 10-year yields to 0.15%. Meanwhile, improving global fundamentals will continue to support investment flows into Asian local bonds, though we expect the yields to rise at a much lower magnitude between 10bps and 20bps from the start of the year for the 10-year papers such as those in India to 7.54%, China to 4.00% and Malaysia to 4.01%.

Long-overdue bond market correction

• Since the start of 2018, developed markets’ sovereign bond yields have been rising. The US 10-year Treasury yields climbed above 2.8%, the highest since early 2014 while the German 10-year yield, which acts as the Europe’s benchmark, also rose above 0.7% to its highest level since late 2015 this week.

• It seems like the bull run in the bond market might finally be over which we feel is long overdue. Despite the US Fed having raised rates five times since late 2015, the bond yields remained low supported by the low global inflation.

• We expect the combination of strong growth and low inflation to continue in 2018, and will now add pressure on bond yields. While structural factors such as the impact of technology remains important, cyclical forces suggest that inflation will begin to catch up with the strength of economic activities in 2018. The reason being, global growth is across the board and not just US-centric.

• Hence, it allows us to set our macro view, leaning towards a reflationary environment driven by a global trade boom that results in a stronger growth and inflation as the upswing pushes commodity prices higher. Also, with the US fiscal reflation, the country experiences a fiscal boost, incorporating deeper tax cuts and increased infrastructure spending, driving inflation higher, which is concentrated in the US.

• These factors support a further tightening of the monetary policy which means higher yields. For instance, we expect the US Federal Reserve to raise rates 3 times this year, each by 25 basis points (bps) and another 1-2 rate hikes in 2019, driven by higher inflationary expectations from a tighter labour market that will see wages grow.

• Elsewhere, the European Central Bank (ECB) and Bank of Japan (BoJ) are steering their respective monetary policies towards a tighter direction. The ECB should end its quantitative easing (QE) in September 2018 and institute a rate hike in 2019.

• The BoJ will continue the yield curve control (YCC) and we can expect the BoJ to raise the 10-year government bond yield target. It will be a turning point towards a tighter policy. Meanwhile, rate tightening is envisaged in many economies in Asian ex-Japan (AxJ), including Malaysia.

Expect short-term volatility

• While the global economy is anticipated to continue its growth path in 2018 with central banks set to normalise their monetary policies, room for volatility in the near term is fairly glaring, including the Malaysian bond yields.

• At the same time, while hoping for a relatively smooth year of positive returns in the financial markets, it is essential to take into consideration of potential upsets that could arise from macro data failing to meet expectations or overshoot expectations, unexpected policy changes, political noises and geopolitical tensions.

• Also, asymmetry or unanticipated shocks could come from the central banks as they navigate towards a new global liquidity pattern. A runaway inflation scare will send interest rate expectation significantly higher and result in a sharp spike in the Volatility Index.

• Since we foresee room for volatility in the bonds yields including Malaysia, investors will need to look beyond beta to meet their return requirements. It is becoming imperative to yield higher returns from fixed income portfolios via asset allocation or security selection, while managing the risks ahead.

Yield outlook

• Looking at the bond yields outlook for 2018, we expect a big jump of 55 to 60 bps in the yields of developed countries from the beginning of the year. For instance, the yields of the US 10-year Treasury is poised to reach 3.00% from 2.40% at end-2017 while the German 10-year yields is expected to jump by 58bps to 1.00% from 0.42% at end-2017 due to the normalisation of the monetary policy. In the case of Japan, we forecast the 10-year yields to increase by 0.10bps to 0.15% from 0.043% at end-2017 on the back of potential BoJ’s policies to address inflationary expectations.

• Meanwhile, improving global fundamentals will continue to support investment flows into Asian local bonds. It should favour countries with strong fundamentals and room for growth potential. Though we presume the yields to rise, the magnitude will be much lower between 10bps and 20bps.

• For instance, looking at India, despite positive fundamentals and reform momentum, we expect a narrowing of liquidity surplus going forward and a potential rate hike by the Reserve Bank of India and a weakening of the rupee against the USD. We foresee the 10-year government bond yields to rise by 20bps to 7.54% in 2018 from 7.34% at end-2017.

• A positive cyclical outlook for China is supportive of growth despite the US trade protectionism being a risk. China central bank’s monetary policy will continue to be neutral with a tightening bias although its fiscal policy will remain supportive with the launch of multiple large-scale infrastructure projects. While the risk of a debt-inspired collapse on the economy is there, chances of it happening are unlikely. We feel the rise in yields does provide opportunities to add long-term bonds. The Chinese bond market tends to deliver high nominal and real income, and benefit from stronger global growth and capital expenditure. Also, we expect the RMB to remain stable against the USD. We envisage the 10-year government bond yields to rise by 10bps to 4.00% in 2018 from 3.90% at end-2017.

• For Malaysia, we project the local bond yields to hold up to the pressure of US Fed rate hikes. We anticipate the US yields to be on the uptrend driven by higher inflationary expectations which suggest the US Fed should raise rates aggressively. We are looking at 3 rate hikes in 2018, each by 25bps. As for Malaysia, BNM has raised the OPR by 25bps to 3.25%. While we expect the policy rate to stay stable in 2018 at 3.25%, there is room for another rate hike should the economic growth rate continues to overshoot. Nonetheless, we foresee the yields differential between the US and Malaysia’s 10-year MGS to narrow due to a much faster speed of rising trend on the US yields as opposed to the Malaysian 10-year MGS yield.

• We believe the 10-year MGS bond yield will rise moderately in 2018, supported by: (1) healthy macro fundamentals with Malaysia’s GDP expected to grow by 5.5%; (2) improving business and consumer sentiments; (3) supportive government policies and regulations; (4) the inflow of funds into the region; (5) lower risk aversion; (6) an undervalued MYR by around 3% - 4% against the USD; and (7) normalisation of monetary policy, thus continuing to drive the demand for local bonds. We project the 10-year MGS yields to rise by 10bps to 4.01% in 2018 from 3.91% at end-2017.

Source: AmInvest Research - 9 Feb 2018