The RBA and RBNZ already cut rates and we expect the Fed to follow soon. If central banks don’t listen, the market will probably force their hand.
With the expected lift-off in Europe and Japan taking a full reversal over the past months, the US and dollar-bloc are more or less the only developed government bond markets where some positive yield is left. This provides a backdrop where any rise in government bond yields will probably be seen as a buying opportunity. This makes us constructive on duration.
The Fed has two choices: either cut soon to satisfy expectations (either 50 bps in one go, or 25 bps cut in June and July), or wait and risk a tightening of financial conditions as risk assets sell off. This Fed appears less in tune with markets than its predecessors, so there is a risk that it could remain behind the curve. This is not our main scenario, though. We think the Fed has learned from the December episode and will cut rates convincingly. If not, they will likely have to cut more later.
ECB President Draghi delivered a dovish message at its latest meeting, albeit failing to fully live up to the dovish market expectations that had been built.
Financial markets have priced out some 3 bps of the rate easing since the news conference. Our view is that it makes sense for markets to keep pricing in at least a 50% probability of a 10 bps cut by year-end. For choice, we think the hurdle for the ECB to deliver that is lower than for a resumption of QE – which only becomes more likely if a broad-based recession were to take hold. In our view, a rate cut would likely be accompanied by measures to mitigate the side-effects of negative interest rates on the banking system, such as a tiered reserve system.
The monetary easing in China so far this year seems to have been mainly targeted at easing financial conditions for POEs/SMEs. While financial markets discount pretty much unchanged interbank repo market conditions over the coming year, we see risks as skewed to the downside. Against this backdrop, we remain positioned for a further weakening of the CNY, which, despite the recent widening of rate differentials, has held at around 6.90 versus the USD.
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