BlueBay AM: The central bank caped crusaders

21 jun 2019

With the dynamic duo of Draghi and Powell once again using their policy superpowers, we are inclined to believe that risk assets can continue to climb the wall of worry.

Yields and spreads across fixed income markets continued to rally over the course of the past week. Dovish comments from Draghi at Sintra drove Bund yields to new lows on anticipation of further possible rate cuts and central bank asset purchases. 

 Meanwhile, the Federal Reserve (Fed) moved to an easing bias, with Powell seemingly teeing-up a July rate cut in anticipation of downside risks coming from trade, at a time when inflationary pressures remain non-existent. 

With the dot plot highlighting a number of participants feeling that rates could fall by 50bps before the end of the year, dovish market expectations have continued to run unchecked, with forward-rate expectations dropping sharply on the observation that the FOMC seems to be happy to follow markets. 

Trump’s criticism of the Fed, and Powell in particular, has also fuelled a narrative that the monetary policy stance is inappropriately tight.

In this context, even though last weeks’ consumption data pointed to another quarter of robust growth, there is a sense that policy orthodoxy is being pushed aside on the thinking that interest rates above 0% represent an anomaly in a world characterised by cash rates trading in negative territory. 

Risks seem tilted to the upside

We continue to hold the view that the Fed requires evidence to act at a time when economic activity is healthy and risk assets are close to their highs. 

However, there is a sense that if incoming information in the next month doesn’t surprise on the upside, a cut now seems something of a done deal. 

Put another way, it seems that with the Fed watching rates collapse elsewhere in the world, against a backdrop of disinflationary forces, the FOMC can afford to err on the side of caution and ease policy, as the risks of a policy error seem limited at a time when US CPI remains below target.

As we assess the market backdrop, we continue to push back on gloomy economic growth expectations. We believe that recession risks remain low and, if the Fed delivers the monetary stimulus that market participants want to see, risks are tilted to the upside. 

Periphery value

On this basis, we believe that a bias to fade the rally in rates continues to make sense to us on a medium-term view. Moreover, a rally in core government yields continues to make more yieldy assets more attractive. 

Italy and Greece have both rallied in the past week, as a grab for yield has driven spreads sharply tighter. 

We have maintained a constructive stance on EU sovereign spreads for some time, on the view that political risks are over-stated in the region and that the likelihood of an EU break-up remains very low. A dovish stance from the ECB has helped to remind investors that the central bank is not out of ammunition and this is a helpful factor underpinning risk appetite.

Spreads in emerging markets and corporate bonds have also benefitted from a grab for yield in the past week. 

As it stands, there is a record volume of negative yielding assets in the eurozone, with growth and inflation relatively stable at low levels. Consequently, a process of ‘Japanification’ is supporting returns for credit investors, as curves flatten and spreads tighten under the gravitational pull of the ‘dark star’ of long-term cash rates stuck in negative territory. 

Proceed…but with caution

At the same time, we feel that it is appropriate to exercise some caution. Valuations in some parts of the market are already stretched, and, with pricing on new deals being revised tighter, it is hard to get too excited. 

We continue to see most scope for performance in the European periphery and maintain holdings in Italy and Greece. Although spreads in these countries have rallied, we sense there is further to go, with the technical backdrop well supported with many investors tending to be underweight in Italy, in particular. 

In FX markets, the US dollar weakened following the FOMC meeting but remains within its recent range. The Norwegian krone rallied on the week following a rate hike from the Norges Bank.

It is interesting to see how monetary policy is going in a very different direction in Scandinavia in contrast to what we see elsewhere in the world.

Looking ahead

It will be interesting to see whether markets can sustain their bullish orientation as we head towards the summer holiday season. With three rate cuts discounted through to the end of 2019, it seems hard to see scope for rates to rally much further, unless growth slows very substantially.

Yet there is a sense that the monetary policy rulebook is being re-written, with the Fed remaining surprised that the ongoing economic expansion doesn’t seem to be doing anything to ignite any price pressures. 

On a separate point, we have seen a growth of quantitative and algorithm strategies chasing the rally they have helped to create, and we wonder if some valuations risk forming a bubble from irrational exuberance. 

It has also been interesting to note the rise of risk-parity strategies, which hedge long equity positions with long positions in fixed income. 

With the rally in yields pushing down rate expectations and hence causing stocks to appreciate, this has created a vicious circle and a need for these types of funds to buy even more bonds. 

At the same time, it is hard to see an immediate catalyst for a reversal in price action if central banks aren’t inclined to push back the other way.   

The G20 meeting next weekend could be a risk event now that markets are becoming more hopeful for a constructive outcome, while tensions in the Persian Gulf also represent another risk catalyst.

Away from this, liquidity scares at some competitor funds may be offering a taste of what lies ahead in the next major market downturn, though on balance, it doesn’t strike us that investors have become excessively positioned at this point (away from rate markets at least).

With the dynamic duo of Draghi and Powell once again using their policy superpowers this week, we are inclined to believe that risk assets can continue to climb the wall of worry here, rather than this being a Del Boy and Rodney moment.