2017 has been a relatively mixed year for the bond market. Corporate bonds, particularly those at the riskier end of the spectrum, have performed well as default rates remain depressed and credit spreads have ground lower. Government bonds, however, have experienced more varied performance. In the UK and the US, short-dated government bonds have underperformed those at the longer end of the yield curve. The US yield curve, as measured by the difference between two- and 10-year treasury yields, fell to its flattest level since 2007 earlier this month, while the UK curve, by the same measure, is as flat as it has been in more than a year. In contrast, the German yield curve steepened, with longer-dated bonds underperforming those with shorter maturities.
To put this year into some context, it is worth considering where we were in financial markets as we entered 2017. Donald Trump had won the US election in November 2016 and was set to be sworn into office in January 2017. The so-called ‘Trump trade’ had led to a rally in equity markets and the US dollar, and weakness in long-dated US treasuries, as a number of the incoming President’s campaign promises, including tax reform and infrastructure spending, were considered to be pro-growth and potentially inflationary. The US Federal Reserve had raised interest rates in December 2016, the only rate rise of the year. In the eurozone, meanwhile, significant political event risk lay on the horizon at a time when the region’s economy, particularly in some peripheral countries, was struggling to build momentum. French and German elections were due to take place during the year, while Matteo Renzi had just resigned from his position as the Italian Prime Minister, following his defeat in a referendum on constitutional reform. The British economy had performed better than had been expected following the country’s vote to leave the European Union, though this was in part due to a boost to certain sectors from sterling’s sharp decline in the currency market. The opposition Labour party was considered weak and its leader Jeremy Corbyn unpopular, with the Conservatives enjoying a majority in parliament.
While some things panned out as many had predicted in 2017, others did not. The strength in the US dollar toward the end of 2016 was quick to fade, with the President Trump’s struggle to repeal Obamacare leading to doubts over his ability to fulfil his campaign promises. Although these doubts have faded more recently, with sweeping tax reforms set to be signed into law in the coming days, the US dollar, versus both the euro and sterling, remains lower than its level at the start of the year, by 12.7% and 8.4%, respectively. Reservations over Trump’s ability to deliver his pro-growth policies have also contributed towards the flattening of the US yield curve. While the Federal Reserve has pushed on with normalising monetary policy by raising rates three times in 2017, weighing on short-dated treasuries, the more positive performance of long-dated treasuries is perhaps reflective of a market that is uncertain on the longer-term growth and inflation prospects for the US economy. Inflation data in the US during 2017 generally surprised to the downside, and, while higher than at the start of the year, the Fed’s favoured inflation measure, the PCE deflator, remains 40bps below the FOMC’s 2% target.
In the eurozone, political events failed to affect financial markets in a significant way during 2017. This was in part due to some of the worst case scenarios being avoided. For example, the National Front was defeated in the French general election, and, in the Netherlands, the far right Freedom Party failed to garner sufficient support in March’s election to earn a place in Prime Minister Mark Rutte’s coalition government. Meanwhile, the impact on government bond prices and equity markets of events such as Catalonia’s government declaring independence from Spain was short-lived and there were few signs of contagion to other parts of the region. The underperformance of longer-dated German bunds, compared to US treasuries and UK gilts, can be attributed to a large extent to the strength of eurozone economic data. The Citigroup Eurozone Economic Surprise Index has been above zero for the entirety of 2017, indicating that on average economic data have been better than expected throughout the year. PMI surveys for both the manufacturing and services sectors are at multi-year highs; the former at its highest level since 1997 and the latter at its highest since 2001. Despite the broad strength in economic data, the European Central Bank has been reluctant to withdraw the elevated levels of monetary accommodation provided to the single currency bloc. Interest rates have remained unchanged throughout the year, and while the bank announced plans to reduce the amount of monthly asset purchases, it has extended the time over which those purchases will be made by at least nine months. The ECB President Mario Draghi has been cautious on the inflation outlook, despite the improving economy, reiterating in December the need for “an ample degree of monetary accommodation to secure a sustained return of inflation towards” the bank’s target.
In the UK, economic data were relatively mixed over the last 12 months. The first half of the year saw data, as measured by the Citi UK Economic Surprise Index, fall short of expectations, as the boost provided by sterling’s fall in the currency market faded and the uncertainty surrounding the country’s exit from the EU took hold. Since the middle of August, however, the data have recovered and the UK composite PMI survey in December was comfortably above the 50 level that separates expansion from contraction. Sterling has generally performed well in the currency market, rebounding from its weak performance in 2016, while the rise in short-dated government bond yields came about in the second half of the year as inflation data surprised to the upside and the Bank of England in September signalled the likelihood of a rate rise in the “coming months”. The Bank of England raised rates by 25bps in November, undoing the rate cut that came in the aftermath of the UK’s Brexit vote, and stated in December that if the economy performs in line with its forecasts then “further modest increases in the bank rate would be warranted over the next few years”. Political risk, if anything, is higher now in the UK than it was at the start of the year, as June’s snap election saw the Conservative party lose its parliamentary majority. In addition, Brexit negotiations continue to make slow progress, despite the recent accord on the size of the UK’s divorce settlement.
Looking ahead, as looking back at the start of the year tells us, making accurate predictions for the coming year can be extremely difficult. That said, economic data and political events will continue to play an important role in the direction of government bonds. Inflation, other than in the UK, is generally below central bank targets and with broad-based economic growth in a number of regions, it will be a data point that will be closely followed. On the political front, Trump’s Presidency and whether he is able to build on his tax reforms may influence US treasury markets, while in the eurozone, Italy is due to hold a general election no later than 20 May next year, and in the UK, Brexit negotiations will remain of considerable focus.
This will be the final Fixed Income Note of 2017. We would like to take this opportunity to thank you for reading over the past 12 months and to wish you a Merry Christmas and a Happy New Year.