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In denial, but for how long?

In denial, but for how long?

11-01-2019 | Insight

In our latest Central Bank Watcher, we examine the policy and actions of the world’s major central banks. The Robeco Global Macro team looks at expectations for growth, inflation and the term premium, for example, and analyzes monetary policy and geopolitics to see how these will affect the macro outlook and financial markets.

  • Rikkert  Scholten
    Rikkert
    Scholten
    Portfolio Manager

Speed read

  • Economic momentum has peaked yet the Fed remains in denial
  • ECB remains on a tightening path, despite weaker data
  • China needs more stimulus, markets price in nothing from BoJ

Since our ‘Tightening in tougher conditions’ update, conditions have been even tougher than we expected. By focusing primarily on the modest loss of momentum in economic data rather than the tightening financial conditions resulting from market weakness, the Fed is running a serious risk of overtightening, according to Rikkert Scholten.

As the pressure builds, we expect a more dovish central bank response. We therefore see a lower rate trajectory for the Fed, ECB and PBoC than markets are pricing in. As long as central banks keep ignoring market warning signals, longer-dated bonds should gain the most. But a greater acknowledgment of downside economic risks should be a signal for curves to steepen.

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Reality to catch up with ECB

With economic data disappointing – leading producer data edging lower, consumer spending momentum weakening – the recovery looks fragile. The ECB is moving in a dovish direction, but at a gradual pace. We believe the ECB will be unable to hike rates in 2019 – although this is largely priced in, the market is still pricing in a 20bps hike for December 2020, and we expect this to be challenged. 

Yield levels are low, but, given the modest ECB outlook, limited free Bund float, limited net supply and positive carry, we favor buying 10-year Bunds at around 0.4%.

Fed hikes now largely priced out

We share the Fed’s view that economic data have remained strong but leading growth indicators have lost momentum. Speeches from influential policymakers have suggested a shift towards a pragmatic, data-dependent stance. However, not acknowledging the deterioration in market sentiment has increased the risk that sentiment in the real economy will lose momentum quite quickly. We have adjusted our view from expecting a pause after March’s meeting to expecting no rates hikes in 2019.

Long-term yields can fall further until the Fed sounds more dovish, a signal for the curve to steepen. All three drivers of yield (central bank rate expectations, inflation expectations and term premium) have contributed to the recent decline in yield. Further out we expect term premium to push the long end up, but only once the Fed starts to sound more dovish. For now, despite negative carry after hedging, we favor long positions in 10-yr Treasuries.

PBoC: more stimulus needed

Official and external data on China are softening. Rate hikes have been priced out, and we think the market will start to price in a 25bps cut for 2019. PBoC Governor Yi Gang recently expressed concerns about tightening global financial conditions, signaling the need for proactive adjustment and fine-tuning in the monetary stance. 

Within a week, the PBoC introduced a new targeted medium-term lending facility (TMLF) for “small and private” firms, including a 15bps reduction in rate. In our view, further stimulus is needed, particularly given the faster-than-expected slowdown in consumer spending.

BoJ: no change on the horizon

After recent moves, the market again expects no hike in 2019, with only 4bps priced in for 2020. We expect no change in rates in 2019 as the BoJ will not put the recovery at risk, seeing current developments on inflation as “relatively weak”. But widening the +/- 0.2% target band is possible, a move that Governor Kuroda stressed should not be seen as a tightening but as a means to improve market functioning. 

The momentum in leading indicators is showing signs of fatigue although jobs growth is supporting consumer growth. But with hiking risk priced out, yields close to multi-year lows and carry and roll down zero for maturities below 10 years, we favor underweight positions in JGBs. 

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