Fixed Income: Reiterate our cautious view on bond market

• Trade friction and sanction will add pressure to global inflation, with no signs of market turbulence coming to an end anytime soon. Hence we reiterate our cautious outlook on government bonds.

• We expect US 10-year yields to reach 3.10% with a high of 3.40%, and the consolidating path at around the 3.10% and 3.20% levels should there be a meaningful sell-off in risk assets like what happened in the early February equity rout.

• Euro yields are looking to climb and the path of the bond yields will depend on growth, inflation and indication from the ECB about the future of QE. We are cautious on German bunds and project the yields would reach 1.00% and could touch a high of around 1.30%.

• UK yields are estimated to be around 2.00% and could reach as high as 2.30% as it depends on wage growth, inflation, the GBP and whether the trade conflict escalates into a full-blown trade war which is not our base case. If that happens, the BoE would be forced to postpone further hikes.

• The MGS yields are moving in tandem with the UST, and the spread has compressed. But the risk sentiment on MGS could reverse the flow position into an outflow. There is upside to the MGS yields despite the fact that the UST’s rising depends on local macro data, strong demand for emerging market bonds, pace of Bank Negara tightening and the ringgit. We project the 10-year MGS yields at 4.20% with the possibility of touching 4.35%.

A. Trade friction and sanction will add pressure to global inflation

• A key theme in our view over the recent weeks has been the revival of the rising inflation and the rising yield story. Oil price has moved above US$70 per barrel and firmer metal prices have fanned worries about inflation, which for much of the post-financial crisis period has remained subdued and helped sustain a rally in bonds.

• We believe trade friction and sanction will add pressure to global inflation through higher oil prices. Metal prices will also climb as US sanctions on Russia threatened to disrupt global supplies of aluminium and other industrial metals.

B. No sign of market turbulence coming to an end anytime soon

• Oil prices have been rising recently, reaching the highest since December 2014. Crude oil price for WTI and Brent are at US$63.49 per barrel and US$67.98 per barrel on average, YTD respectively (See Chart 1 and Chart 2).

• While geopolitical worries drove up prices, we are concerned about the potential negative impact on the economy, oil demand and prices from Trump's trade positions. For now, there is no clear breakthrough ahead between the US and China on trade. Thus, it could impact commodities more than the actual fundamentals. With no clear signs of the market turbulence coming to an end anytime soon, we can expect global assets to undergo an accelerated pace of risk-on or riskoff scenario.

• We revised upwards our WTI and Brent outlook by US$6 to US$63 per barrel and US$66 per barrel respectively for the full-year average of 2018 as we expect the high volatility in oil prices to continue, due to the push-pull of geopolitical and policy risks. (See Chart 3 and 4)

• In 2019, we foresee an increase in oil supply coming from Canada, Brazil and elsewhere, along with the pipeline bottlenecks. It can result in a wider spread between Brent and WTI. At the moment, the spread between WTI and Brent is about US$5. Room for the spread to widen to as much as US$8 to US$10 a barrel in 2019 cannot be ruled out.

C. Reiterate our cautious outlook on government bonds

• Inflation will play a key role in influencing the bond market. Rising inflation and an easing of the global interest rate suggest that long-term interest rates will head for a higher shift. Thus, we reiterate our cautious view on the bond market, especially if the US 10-year yields push past 3%, it will signal the start of a bear market. It is already underway. The US 10- year yield tried to breach the 3% psychological level before it pulled back to settle at 2.975% with a gain of 2.4 basis points (bps) on April 23, the highest level since January 2014, after touching an intraday high of 2.996%.

• Bond yields in Europe and Asia shot up in April 23, possibly in reaction to the US 10-year yields trying to surpass the 3% level. The rates on German bunds and JGBs bounced off from near-term lows to 0.63% and 0.06% respectively while the Asian markets experienced high yields as seen in the Malaysia 10-year MGS touching 4.167% (See Table 1).

D. Maintain our negative view on US yields

• Apart from rising inflation expectation from higher energy prices, the fiscal stimulus (tax reform passed in December 2017 and early 2018 budget agreement) to boost growth should see federal deficits rising fast and approaching US$1 trillion per year over the next three years which will also add to inflation apart from growth.

• Thus we have a cautious outlook on the nominal government bonds with a tightening monetary stance. Our focus will be on the US yield curve which is expected to flatten. Should the spread between the US yields 10- and 2-year which has been quite flat at 50bps as of April 23 steepen sharply, it may signal the Fed’s willingness to accommodate a certain period of above-target inflation or staying behind the curve in its efforts to control inflation (See Chart 5).
• If the Fed decides to accommodate the above-target inflation rates, it will spark stronger volatility as it is viewed as a departure from its long-standing commitment of a 2% target. Alternatively, if inflation rises and the Fed is forced to tighten its monetary policy faster than envisaged, it will cause volatility.
• We believe our 2018 US inflation projection of 1.9% will likely be surpassed, possibly crossing the 2% target set by the US Fed largely due to rising energy prices. With a rising inflation expectation, we expect the Fed to step up the pace of monetary tightening from another two more rate hikes to three in 2018 rather than to accommodate a certain period of above-target inflation or stay behind the curve.

• Hence, we can expect the spread between the US 10- and 2-year yields to likely stay flat. The market has priced in a 36% chance of a fourth rate hike from a previously 23% chance. We have also revised upwards our probability to 40% from 25% previously for a fourth rate hike.

• We have now revised upwards our base case projection for the US 10-year yields to 3.10% from 2.96% previously with a high of 3.40%, suggesting the bond market has fallen into our bearish view. Even if the 10-year yields do consolidate to around 3.10% and 3.20% levels should there be a meaningful sell-off in risk assets like what happened in the early February equity rout, it is it still in the bear market region. Should there be no such sell-off, the 10-year yield is likely creep higher to reach 3.40% (See Chart 6).

E. Pressure on euro yields to rise

• Although the bond yields in the eurozone rose to 0.634% on April 23, it is still below the peak of 0.765% in February 2018. We believe weaker-than-expected economic data has cast doubt on the future pace of the European economic recovery, leaving eurozone yields lagging behind Treasuries.

• We feel the Euro yields are looking for a floor. Hence, the path of eurozone bond yields in the coming months will largely depend on growth and inflation data. While we are hoping to get some indication from the ECB about future quantitative easing in July, we believe the ECB will end the QE by end-2018.

• Thus we are cautious on German bunds. We project the yields would reach 1.00% and could touch a high of around 1.30% (See Chart 7).

F. Upwards force on UK yields

• The UK yields touched 1.537% on 23 April, rose 18bps MTD. Apart from the rise in US yields, we suspect the potential rate hike by the Bank of England (BoE) in May and probably another hike in November have lifted the yields.

• Though the UK data weakened in 1Q, wages grew faster than inflation in February for the first time since March 2017. We are pricing a 70% chance of a May rate hike by 25bps to 0.75% despite the market’s 54.4% which could be due to the economic and political uncertainty in relation to Brexit. This was the case when the US Fed started its hiking cycle. Room for another rate hike in November is still in the cards.

• We project the yields at 2.00% and could reach as high as 2.30%. Much depends on the direction of the wage growth, inflation, the GBP and whether the trade conflict escalates into a full-blown trade war which is not our base case. If that happens, the BoE would be forced to postpone further hikes (See Chart 8).

G. MGS yields on rising trend

• The MGS yields are moving in tandem with the UST. The movement of the latter is being influenced by the inflation expectation which is envisaged to surpass our 1.9% full-year projection and the 2% target set by the Fed due to rising energy prices. This has raised our probability for the Fed to hike rates from another two more times to three in 2018 to 40% from previously 25%. Markets are now pricing for three more rate hikes.

• In the case of MGS movements, these will be supported by macro fundamentals with 2018 GDP projected to grow by 5.5%; low inflation of 2.5% for 2018; an undervalued USD/MYR of around 4% – 5%; positive foreign inflows; and another rate hike to normalise the policy rate to 3.50% which we have raised the chance from 30% to 45% in 2H2018.

• But the risk sentiment on MGS could change when foreign funds reverse their flow position into an outflow. Headwinds could come from external noises like changes from the global macroeconomic settings with the US Fed becoming more aggressive in its rate hike policy, geopolitical tensions, full-blown trade war and sanctions.

• We noticed the spread between the UST and MGS has compressed from a high of 144 bps on January 2 to 119 bps on April 23. With a US 10-year yield outlook at 3.10% (with a high of 3.40%) due to a higher inflation expectations and faster pace of normalisation by the Fed while the rise in MGS yields contained by macro fundamentals, strong demand for emerging market bonds, pace of Bank Negara tightening and stronger ringgit in 2018, we project the 10-year MGS yields at 4.20% with the possibility of touching 4.35% (See Chart 9 & 10).

Source: AmInvest Research - 25 Apr 2018