Volatility on the equity markets was mainly fuelled by strong inflationary fears, but movements in inflation-linked bonds convey a more moderate message.
The latest upward move in core nominal yields, which began in early December, was more down to the rise in real rates than higher inflation expectations. Real rates have moved to reflect the upgrades to growth forecasts. Valuations therefore remain attractive on inflation breakevens, and they are likely to rebound in response to the inflation upside surprises we expect to see in the United States this year: in particular, underlying inflation, for which expectations remain modest, should be driven by the economic cycle. The inflation breakeven curve remains flat on these two areas, and the premium on the longest maturities still seems very low to us given the current stage of the economic cycle. We are therefore positive on inflation breakevens for the US and Europe, and favour long maturities.
The new Fed chairman is now in place and has already expressed his confidence on inflation going forward. Meanwhile, an increasing number of Fed board members are talking openly of the need for more monetary tightening. And we think they have a point: the tax reform approved in December was accompanied by new budget spending measures from the start of the year, and these two factors should lead the Fed to upgrade its GDP growth forecast for 2018; inflation should pick up and wages are expected to rise given a tight labour market, which would provide sufficient grounds to quicken the pace of monetary normalisation. We should therefore see further rises in US short-term interest rates. Nonetheless, the Fed - along with the central banks of the major developed countries - will be careful not to hike rates too high, too soon, as this may weaken growth.
In the eurozone, real rates remain very low compared with the rest of the world and in light of the economic scenario: as in the United States, normalisation will likely take place when the ECB’s QE programme comes to an end. At such a low level, they are vulnerable to any comments in this area by the ECB and to events in North America.
The reconnection of core country rates with the economic fundamentals remains our central scenario, although we don’t see this being a linear process...