Finding a New Range and Speed of Adjustment

February 2018

The increase in market volatility since the release of the January U.S. labor market data suggests that the low-rate, low-volatility environment is being challenged and probably coming to an end. Last year we began to argue that the world was moving into a synchronized economic upswing that was truncating downside (disinflationary) risks and pushing growth and inflation outside of their post-crisis ranges. This normalization of economic performance meaning steady, strong growth, rather than the start/stop behavior we have experienced over the past 10 years, means markets should "normalize" as well: more volatility and higher yields. Low and falling inflation last year muted if not negated this effect. 2018 is unlikely to be so lucky. As we saw in January, this means higher yields, nominal and real, as growth and inflation expectations do not mean revert as they have since the end of the global financial crisis.

As a result of these forces, yields in developed markets are likely to spend time searching for a new, most likely higher, range as this economic expansion continues. For nongovernment bond markets, there will be tension between higher volatility negatively affecting valuations and positive fundamentals in terms of corporate/EM cash flow and economic momentum. As always, how central banks react to this changing economic and market performance landscape will determine how this tension is resolved. What new yield range is established and how fast yields adjust will be key to bond market performance in the period ahead. In this transition period, hold on to your hats!