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Beware the monetary tide is turning

Beware the monetary tide is turning

24-10-2018 | 四半期アウトルック

Tighter dollar liquidity and a trade war that is fast becoming a deeper economic struggle will continue to affect markets. The monetary tide is turning and the QE reversal has begun. Going forward, it will be the US that determines liquidity and China growth, while Europe accepts the consequences. Fred Belak, head of Robeco’s Global Fixed Income Macro team, expects yield curves to steepen and rates to move higher. He recommends being underweight duration, long US dollar and cautious on risky assets.

  • Fred Belak
    Fred
    Belak
    Head of Global Macro

Speed read

  • Fed tightens, dollar strengthens and EMs feel the pain 
  • Deeper economic power struggle underlies trade war facade
  • US procyclical fiscal policy is a tail risk

“US financial conditions need to tighten to prevent the economy from overheating. Shrinking global US dollar liquidity will lead to a stronger dollar and, at some point, broader risk markets will start to suffer alongside their emerging counterparts,” says Belak. “The Fed will continue hiking until the negative effects this has the world economy will start to be felt in the US, putting a brake on growth there too. We think more rate hikes for 2019 will be priced in in the next few months, pushing up the US dollar. But that the Fed will be forced to take its foot of the gas at some point – something the markets expect to happen.”

More to it than just trade

Emerging markets will remain very vulnerable to higher US rates, reduced dollar liquidity and a stronger dollar. “The US is waging an economic war against China,” according to Belak. “This will cause supply chains to shift and become less efficient, and although China is able to respond – and it will – we are unlikely to see the Chinese economy bounce back strongly”.

“Why? President Xi Jinping is serious about de-risking and ensuring that China continues its transition to a consumer-driven growth model, so he will not approve large scale re-leveraging and is willing to live with the impact this will have on growth. Massive fiscal spending is also unlikely, simply because in the past this has proved to be an ineffective way of stimulating the economy,” he concludes.

Italy still dominates the headlines and markets in Europe. Belak: “Spreads above 280 basis points over Bunds are high enough for us to have shifted to a neutral duration position in Italy. The current coalition has been forced make considerable concessions on its budget and, we believe, is using the Bannon playbook to its advantage while blaming the EU for any compromises. We expect Italian risk premiums to remain high and do not expect to be overweight Italy versus our benchmark.”

“Draghi’s comments about expecting a vigorous increase in inflation lead us to believe that pressure is mounting within the ECB to allow bond yields to rise. We are underweight European bonds and prefer to implement this via French government bonds rather than Bunds due the relative scarcity of the latter and the redenomination premium they will command in a crisis. Japan has undergone a major policy shift and is focused on improving the velocity of money in the economy by allowing banks to make profits via positive rates and a steeper curve. We are heavily underweight duration versus the benchmark in Japan and expect yields there to rise.”

Keep an eye on the free float

“After a decade of QE policy, the lack of fixed income asset classes with appealing valuations is hardly surprising. But it’s all relative,” says Belak. “One key feature of the normalization of monetary policy and quantitative tightening is the difference in free floats – the percentage of sovereign bonds outstanding held by the private sector – from one market to another. The US Treasury free float (around 50%) is far higher than the Bund free float (15% according to a revised ECB estimate), which will make it easier for Treasury yields to incorporate a higher term premium.” 

“Emerging market local debt valuations have improved, with spreads on hard currency debt now higher than those on US high yield. But we are quite cautious about this asset class given the risk posed by dwindling USD liquidity. On the credit front, Europe now looks cheaper than the US, especially if you take hedging costs into account. And with the Fed set to continue hiking, Europe is likely to remain more attractive, particularly on a cross-currency hedged basis.” 

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Shrinking dollar liquidity, increasing US Treasury supply, higher hedging costs

“Gross US Treasury issuance is expected to increase by USD 200 billion next year as President Trump’s spending spree continues, while net supply in European government bonds will gradually pick up too,” explains Belak. “But on a more positive note for technicals, redemptions are likely to lead to a doubling of re-investment flows in the coming months. And although European corporate bonds will have to adapt to a market where the ECB is no longer a net buyer, we think this transition is already largely reflected in prices.”

“Foreign demand has been a positive technical for US Treasuries, but this demand has slowed in recent quarters, probably because of rising hedging costs. Declining US dollar liquidity is probably the most important negative technical for emerging debt. If the Fed balance sheet reduction evolves as planned, the decline in the monetary base will accelerate from -5% YoY to about -10%.”

Global top-down investment framework for bonds

The figure summarizes the Global Fixed Income Macro team’s views on the attractiveness of government bond markets and specific fixed income assets, based on valuation, technicals and fundamentals.

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