Chief Investment Strategist and Chief Economist
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Despite the recent rise, we expect the rebound in developed market bond yields to remain limited.
A long trend of declining bond yields has been arrested amid considerable new uncertainties over the tactics of the European Central Bank (ECB) and Federal Reserve (Fed). While headline inflation has started to rise with the oil price recovery, we expect central banks to respond very cautiously to this development and continue efforts to sustain economic recovery. As such, we expect the rebound in developed market (DM) bond yields to be rather limited. While emerging market (EM) and petrol-linked markets have rebounded sharply and may be subject to downward corrections, we see these assets as well positioned for longer-term, if more gradual, appreciation.
On 20 October, the ECB left significant uncertainty over the pace of its asset purchases, but did note that an “abrupt ending” to quantitative easing was unlikely. The Fed appears to be pushing ahead with modest tightening steps. A US rate hike is most likely in December, but early November cannot be ruled out despite the historical precedent of it avoiding moves close to US elections. The timing of both the Fed’s first hike in a year and the ECB’s key policy update in December suggests the risk of a repeat of the turmoil seen at the start of this year, albeit a milder one.
We would expect far less impact from further hikes by the Fed, given the less vulnerable backdrop for global oil producers and the Fed’s signals that it no longer expects to tighten policy by so much. The 0.5% rise in the Federal funds rate it has pencilled in for 2017 is unlikely to be highly disruptive for EMs. The Fed has also conditioned markets to expect that monetary tightening will only proceed if the US recovery remains on track.
Nonetheless, the rise in the bond yields of the lowest-yielding sovereigns has impacted all global markets amid historically high correlations. Foreign exchange hedging costs have risen sharply, perhaps also contributing to reduced transmission of easing by the ECB and Bank of Japan in global asset prices. Equities in sectors such as high-yielding utilities and gold have fallen in value faced merely with mild bond market pressure. However, we continue to see more positive signs on the duration of the global economic recovery and see relative value in equities and credit versus most DM bonds.
Amid the rise in uncertainty over the monetary policy outlook, the Citi Private Bank Global Investment Committee left its asset allocation unchanged. This has halted declines in Developed Market (DM) bond yields. Global equities remain neutral with fixed income underweight by 1.0%. Cash and gold have small tactical overweights. Emerging market (EM) weightings are above DM weightings, particularly in fixed income assets.