In our new Central Bank Watcher, we examine the policy and actions of the world’s major central banks (Federal Reserve, European Central Bank, People’s Bank of China and the Bank of Japan). 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 going forward.
According to Rikkert Scholten, after the recent rally in bonds, there is some room to price in a more hawkish trajectory for both the Fed and the ECB, but this remains limited. Yes, we expect continued hikes by the Fed and a start of the tightening cycle by the ECB, but these expectations are largely priced in already. Does this situation imply that central banks have taken the art of guidance to the next level, or will it mean that unexpected events – more volatile oil prices, a spike in inflation, further deterioration in Italy have far more impact?
Between now and the end of 2019, 70 bps in rate hikes are priced in for the Fed. This is still 30 bps below what is expressed in the Fed’s most recent dot plot, but as markets tend to have difficulty in pricing in dots further out, we judge the current pricing to be about as good as it can be. Only a higher dot plot would justify a further move upward in short-term yields. But, with inflation expected to remain close to target and the first signs of risky assets coming under pressure, we don’t think there will be much appetite to push up the dots.
As for the ECB, the first rate hike has already been endorsed by Draghi and has been priced in by the market. So probably no surprises here either. The deposit facility rate is likely to be increased by 15 bps in September or October 2019. We are less optimistic on core inflation than the ECB, with a forecast of 1.2% by the end of the year (compared to the ECB’s forecast of 1.5%). Although inflation expectations are generally stable, a volatile oil price, for example, could throw a spanner in the works.
Limited room to price in a more hawkish rate path
As could the political backdrop in Europe, which is an area of focus for the region. However, despite the imminent end of the ECB’s bond buying program, it still has a card up its sleeve in the form of its reinvestment policy. This can offer the central bank a tool to continue to help the markets out with liquidity if things start to go sour.
With an upward trajectory for short-term rates already priced in and stable inflation expectations, we expect the term premium to be the main factor driving bond yields in the coming period. The US is further advanced in the tightening cycle, is seeing a rapid increase in net issuance and has a much larger free float of sovereign bonds than Germany, for example. As a result, we expect US Treasuries to be the most vulnerable market when it comes to rising term premiums and so we expect the US Treasury curve to steepen. For Germany there is less room for curve steepening at this point in time.
The Chinese curve has flattened recently and the spread between Chinese government bonds and US Treasuries has tightened significantly. China is not unique in trading at a low yield relative to the US. Canada, Germany, Australia and the UK are in the same camp. But many EM countries would experience wider spreads if their currency depreciated as much as the renminbi has, China, however, is different. This shows that Chinese government bonds are acting as a true safe haven. We expect continued divergence in economic conditions between the US and China and see room for this spread to tighten further.