Geopolitical issues have moved to the foreground during 2016 with respect to their impact on the perceived macro risk conditions in capital markets. Following the sell-off in equities and commodities in February on concerns about weakness in global GDP growth, especially in China and the Eurozone, there was a subsequent recovery of sentiment as the world’s central bankers stepped up monetary accommodation.

The Brexit decision was not widely anticipated by market participants, disturbing develo s not been articulated and there are conflicting tendencies – including a more protectionist stance toward global trade – that might not translate into the increased GDP growth that many in the markets expect.

Going into the Thanksgiving holiday, US equity markets were at record highs, 10-year US Treasury note yields had moved up to around 2.3% and the US dollar had strengthened. The consequences for the Asia Pacific region and Mexico have been far less bullish. Asian currencies were under pressure and capital was flowing out of many EM markets. Concerns that China may be approaching a dangerous degree of leverage within its banking system – some have even claimed that China is facing a Minsky moment – are likely to lead to continuing risk aversion with respect to potential capital inflows to the Asia Pacific region

For institutional asset managers in developed markets, all of the previously discussed issues have contributed even further to the challenging macro financial environment, which already has extraordinarily low yields – in many cases negative – on fixed income instruments.

Recent evidence suggests that more than $10 trillion of bonds (especially those issued by highly rated sovereigns in the Eurozone) are trading with a negative yield. This poses significant challenges to pension funds and insurance companies in particular as their liabilities continue to grow whereas the yield from their asset deployment continues to decline. It is worth pointing out that the ECB is prolonging its asset purchase program well into 2017 and is currently able to purchase sovereign debt as long as its yield does not fall below its current threshold of negative 40 basis points.

currencyIndeed to understand how yields will continue to remain negative for some time, one should consider the role of the ECB in the markets over the next year or so while it continues to purchase about €80 billion of bonds per month. Market participants clearly have an incentive to purchase negative yielding bonds on an interim basis in the knowledge that they can then sell them to the ECB when their yields become even more negative. For example, 10-year bonds issued by the German government have been auctioned at prices above par – guaranteeing a loss if held to maturity. However, if traders were to buy such issues, they are expecting that eventually the ECB might buy those very bonds with an even higher premium to par.

Negative interest rates also pose significant problems to those engaged in risk management and quantitative finance in that modelling tools used for derivatives and by treasurers are not readily equipped to handle negative inputs for discount factors and returns. The learning curve for dealing with these new risk challenges continues to remain steep.

Going into the Thanksgiving holiday, US equity
markets were at record highs, 10-year US Treasury
note yields had moved up to around 2.3% and the US dollar had strengthened

In conclusion, I would suggest that a key indicator to monitor closely as we move into 2017 will be forward inflation expectations. Before the US election, the five-year forward inflation expectations were suggesting that the average inflation rates moving up to 10 years out were very subdued – about 1.6%. Since the US election, the expectation has risen by more than 50 basis points to 2.1%. Given the fact that many investors have been buying large amounts of long term bonds with relatively low coupons, duration risk mus t be upper most in the minds of asset managers, banks and regulators.

Clive Corcoran has been engaged in the finance and investment management sectors, on both sides of the Atlantic, for more than 25 years. An author of several books on international finance, focusing on asset allocation and risk management, he is also very actively involved in executive education for finance professionals worldwide