The European Central Bank (ECB) is likely to adjust its forward guidance before year-end in response to stronger economic momentum, although a strong euro is taming inflation prospects.
The US Federal Reserve (Fed) has started to reduce its balance sheet. We expect one more rate hike by year-end.
The Bank of England recently hinted that it may raise interest rates soon. We don’t buy it – but the market does.
Favour short maturities and inflation-linked bonds.
Monetary normalization to continue in the US
"The Fed’s projection of three hikes in 2018 will be called in to question if inflation struggles to gain traction and growth disappoints."
The recent growth pick-up has helped inflation bottom but we should not expect a strong rise as structural factors remain disinflationary. Central banks are moving very slowly as they must first roll back their ultra-accommodative policies.
Prefer short maturities. After a period of choppiness, we expect US long-term bond yields to head north, supported by Fed rate hikes and slightly stronger inflation. This could widen the yield gap between German and US bonds. However, we expect some narrowing from 2018 onwards as eurozone core bond yields are excessively low. In the UK, Gilt yields are in limbo as the economy is experiencing both slower growth and high inflation. In the eurozone, peripheral bonds offer an attractive carry, but further spread compression will require economic improvement. Overall, we still prefer short maturities and inflation-linked bonds.
Fed – more rate hikes. Normalisation will continue – we believe the soft patch in inflation was transitory and that the Fed’s ultra-loose monetary policy is not compatible with the current and future economic outlook. The central bank is also starting to reduce its balance sheet and the size of the cuts will grow every three months. This combination has the potential to disrupt markets. The Fed will need to manage market expectations to avoid a disorderly sell-off in bonds.
ECB and BoE to follow suit
"The Bank of England has turned more hawkish to curb fast-growing credit growth and tame inflation."
ECB to adjust its stance. With stronger growth but tame inflation, we can expect a rising number of monetary policy committee members to vote in favour of reducing asset purchases from early 2018. This means the quantitative easing scheme would be extended beyond December 2017, in line with market expectations. However, we believe a rate hike remains off the table, although the central bank may begin to make technical adjustments to policy settings to pave the way for gradual monetary policy normalization. However, the ECB will avoid any move likely to drive the euro higher and we think it is in no rush to raise its deposit rate, currently at -0.4%.
Bank of England – hike it or not. The central bank recently hinted that it may raise interest rates soon. We believe this is premature – growth is slowing, the pass-through of last year’s sterling devaluation onto inflation is weakening and Brexit uncertainty will linger long. Still, the market assigns a 80% probability that the Old Lady will go ahead. This may provide further support for sterling in the near-term but may just end up accentuating the weakness in the economy.
Sources: SGPB, Bloomberg, 05/10/2017. Past performance should not be seen as an indication of future performance. Investments may be subject to market fluctuations, and the price and value of investments and the income derived from them can go down as well as up. Your capital may be at risk and you may not get back the amount you invest.