• Global fundamentals remain unchanged despite higher yields
  • No clarity on why US 10-year real rates spiked
  • A dollar bounce could hit economic confidence

While there was general acknowledgement that this year would indeed bring more volatility to financial markets, the sharpness of February’s stock market moves was still surprising. With hindsight, the stock market gyrations did not reflect dramatically altered perceptions of inflationary trends, nor of fears of faltering economic growth, nor of hawkish central bank policies. 

The narrative of robust and synchronised global economic growth coupled with still-subdued inflation, remains essentially intact. Yields on US Treasuries and German Bunds have been trending higher since the fourth quarter of last year, and at a fairly digestible pace. Although rates are certainly higher than witnessed for several years, in the context of a higher oil price, strong global GDP growth and falling unemployment, US rates are no more than heading to ‘fair’, and Bund rates are arguably still too low, given macro fundamentals.

Although the global backdrop has remained supportive of risk, it would be right to question the triggers of the sell-off. Some observers wonder whether stretched positioning and technicals drove the setback and, if so, whether global liquidity could be diminishing faster than thought. Central banks are undoubtedly no longer increasing their balance sheets, while at the same time global net savings may be falling faster as people in Japan, Europe and China chose to save less as economic prospects improve.  

With Germany’s grand coalition finally emerging from the long and messy negotiations, there may be a renewed sense of optimism about European politics. The coalition will be strongly pro-EU and together with French president Emmanuel Macron’s views on closer financial integration, there seems to be an optimistic alignment of outlooks for the EU. Peripheral spreads have already tightened, and there could be more to come.


Both US nominal rates and inflation breakevens have been trending higher this year, which means that real (inflation-adjusted) rates in the US have remained quite steady. In a steady-real-rate environment, where higher rates are driven by higher economic growth, risk has historically been well supported. 

However, at the end of January, US 10-year real rates started moving more sharply higher, and risk assets began to sell off. The underlying triggers for real rates to lurch higher are still unclear, although they might be linked to the prospect of the Trump administration’s unfunded fiscal stimulus plans.

us 10 year breakeven inflation rate versus oil

US 10-year inflation breakevens have been tracking the oil price fairly closely for several years. With higher demand for energy from a growing global economy balanced by the prospect of higher supply from US shale, the outlook for oil prices is reasonably positive and it seems unlikely that dangerously higher inflationary forces may come from macro trends in the oil market.

As long as there is a lack of inflationary pressures in the global system, scepticism about its ongoing absence is likely to persist. Although it may be too early to herald the return of significantly higher inflation on the back of one set of stronger-than-expected US wage inflation news at the start of February, it is understandable that rates are sensitive to inflation news in particular. 

Although emerging market (EM) credit was particularly volatile, EM assets performed reasonably well relative to others, and retraced most of their losses. There is much to commend about EMs – from the robust and stable macro conditions, to the ongoing reductions in systemic risk, which have boosted stability, and their resilience to shocks.


A question for foreign exchange (FX) is whether the dollar’s longer-term downtrend will be re-established, following its reversal after the release  of US wage data in early February. Although FX markets were not the focus during the wild swings in stock markets, it may be careless to dismiss the recent strengthening of the dollar as some sort of ‘collateral’ reaction.

Economic theory informs us that when the global economy is growing, the dollar, as the world’s funding currency, would tend to weaken. A short-term increase in the dollar, as well as a rise in volatility from such very low levels, is unlikely to cause corporate decision makers around the world to withdraw from their capex expansion plans. If volatility stays high, however, or if the dollar stages another significant bounce, then confidence in the economic outlook may take a hit.

If the US does turn on the fiscal taps to fund more growth, this may have the dual effect of pushing the Federal Reserve to hike interest rates, as well as pushing the dollar lower if worries emerge about growing budget and current-account deficits. In the past, these concerns have nearly always led to a weaker currency.

Although the dollar may well enjoy further gains, until there is a meaningful shift in the global macro data, the longer-term outlook stays poor. However, the trend for the euro towards policy normalisation on the back of improved growth prospects and inflation outlook, should remain in place, and should stay currency supportive. And emerging market currencies, certain to be buffeted if the dollar rises further, should benefit from their (unchanged) rosy economic outlooks. Performance will be less uniform in the face of rising volatility.

Safe assets in short supply as demand increases

The shortage of ‘safe’ assets is a recurring theme in studies about the great financial crisis. As safe interest rates reached the effective lower bound, while demand for safe assets soared, this became the tipping point for the global economy. At this point, the shortage of safe assets had damaging macroeconomic consequences, which pushed the global economy into recession.

Some argue that, in embarking upon their massive asset-buying sprees, central banks have exacerbated this shortage, to the detriment of future global financial stability. Others point out that the inexorable growing demand for safe assets is not only down to QE operations, large though they are.

The supply of safe assets, mainly from the US and a few other advanced economies, has not kept up with global demand, as growth in emerging economies has greatly outpaced that of the developed world, where the safe assets are produced. 

In The Safe Assets Shortage Conundrum, published last summer, the authors analyse possible solutions. These include the issuance of more public debt, the production of private as opposed to public safe assets, and increasing the valuation of safe assets through exchange rate appreciation. 

The authors acknowledge the difficulties and ask whether reducing the demand for safe assets might instead be more successful. They point to two avenues in particular – today’s regulatory framework and the safe asset ‘hoarding’ by central banks world-wide.

Basel III requirements have greatly increased the mandated safe holdings of financial institutions, and the authors wonder whether there might be a different way to safeguard stability without generating such high demand for safe assets. They also suggest fundamentally “reconsidering how and why central banks hold safe assets as reserves”.

Years hence, when China is no longer an emerging economy, it may become the provider of huge amounts of safe assets, but for now, the world shortage is acute and will continue to pose a threat to financial stability.