The past few weeks have seen rates trend upwards across developed markets, particularly in the US. The presence of hawkish voices in the Federal Reserve is not necessarily breaking news, nor is the possibility that the Fed might finally hike rates post US elections. However, the recent increase mostly impacted the longer-dated interest rates, while the short end of the curve remains anchored, leading to a steepening of the US curve (refer to graph below). And the reason for this is primarily the rise in inflation. 

US Treasuries curve (July vs Today)


Reflationary trends mandate short duration to developed markets

What started off as the result of base effects and oil price stabilization has now materialized as a broader trend. Indeed, wage increase finally seems to have materialized in the US, while macro-economic uncertainty is ebbing away. While Europe appears to lag the US in relative terms, the picture is still encouraging compared to recent history. Even in the UK, where the “Brexit” issue continues to send ripples in the markets, the sharp decline of the Pound Sterling has the country importing inflation in rapid fashion.

Long term inflation swaps

These strong reflationary trends are likely to have a significant effect on developed market rates, after a long period of zero interest rates and unconventional monetary policies. If the decline in yields was sharp and acute (leading to stretched valuations), the reverse is likely to be rather volatile and abrupt in nature. With this in mind, a shorter duration exposure to developed market curves is appropriate at this juncture. 

Accommodative Central Banks at a turning point

The Federal Reserve has been exceedingly cautious in its policy normalization cycle, but even its most dovish members are now recognizing that a rate hike should be justified based on the growth and inflation outlook. And while future hikes are likely to be gradual, the trend for rates is clearly upwards. At the same time, the very accommodative ECB is also facing a dilemma. The improvement in data has been relatively slower, but still significant, so much so that the relevance of QE has been called into question recently. And in the UK, even a cataclysmic event such as the Brexit vote has led the government to point to its preference for fiscal accommodation rather than monetary stimulus. All in all, central bank easing appears to be going out of fashion, reinforcing the relevance of shorter duration. Once again, it is important to maintain caution and realize that the ECB is unlikely to taper just yet. And in light of the sell-off triggered by M. Bernanke’s “taper tantrum”, M. Draghi will need to tread very carefully. Furthermore, as Brexit impact materializes, political risk will punctually resurface. Tactical management is hence key in this environment where event risk is clearly omnipresent.

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