An irrational week for markets as the Brexit shambles rumbles on and Turkey flairs up to provide a touch of EM drama.
The past week has witnessed a substantial rally in global bond yields as investors have moved to price in increasingly dovish projections with respect to central bank policy. Global growth worries have seen a flight towards duration, pushing 10-year Treasury yields below current cash rates, as interest rate futures price a full interest rate cut later in 2019.
This inversion of the yield curve seems to have been an additional trigger to buy bonds from model-driven investors, who may conclude that such a move means that a US recession is now highly likely.
Looking beyond the illogical
However, we see this logic as highly irrational. We continue to project US GDP growth of 2.5% in 2019 and although the first quarter has been weak activity-wise, we would note that this has typically been the case in the past five years when average first-quarter growth rates have been only 1.5%, compared to 3.6% in Q2.
From our perspective, the US economy is driven by the consumer (as opposed to exports or manufacturing in the case of Germany or China). With employment growth remaining strong, wage growth accelerating, tax burdens falling and consumer balance sheets in their best shape in 12 years, we project that strong growth in disposable income will drive robust gains in consumption and ensure that GDP growth remains above trend for some quarters to come.
Data-dependant health indicators
Meanwhile, financial conditions have eased, erasing two thirds of their 2018 tightening. We are inclined to believe that economic cycles don't die of old age, they end when financial conditions are too tight – but this is not currently the case. In the week ahead, we will look for retail sales and labour market data to show that the US economy remains in good health and predictions of its demise are well wide of the mark.
In the eurozone, the rally in Bund yields below 0% is at least more understandable, in the wake of soft PMI numbers last week. With the European curve remaining relatively steep, Bunds are anchored by ultra-low cash rates. Meeting investors in Japan this week, it seems that currency hedged investors are looking to add to their eurozone holdings in the months ahead, at least once Brexit, EU elections and an extended 10-day national holiday at the start of May are all out of the way.
ECB to walk a familiar path
Meanwhile, ECB discussions around deposit tiering gathered pace in the past week. It seems that the ECB is set to follow in the footsteps of the BoJ and end the annual EUR8bn tax being imposed on excess reserves in the banking sector, in the context of negative interest rates. We have viewed this as a likely step, which should be beneficial to European banks, coming on the heels of the TLTRO extension and something that has become a more pressing need as markets push out projections as to when monetary policy in the eurozone can begin to tighten.
In the UK, the Brexit shambles remained a sideshow – even if it seems that Westminster is becoming such a dysfunctional farce that many are losing interest in the ongoing machinations.
At the time of writing (with Brexit newsflow continuing to come thick and fast), it appears that the UK is headed for a long Brexit extension – possibly until the end of 2019. In this case, we should expect to see a new Conservative prime minister soon, and although it is hard to predict who will take over from Theresa May, it seems likely that the successful candidate will be a more fervent Brexiteer than the incumbent.
In light of this, we see any new prime minister as likely to struggle to negotiate a more favourable deal with Brussels than the one already on the table, and so risks of a hard Brexit have not gone away – but they may be deferred. At the same time, political upheaval may also make a general election possible (and something which is more likely at this stage than another Brexit referendum). In this context, a Labour victory is quite possible and we continue to think that UK assets materially under-price this political risk, especially Gilts with yields below 1% on 10-year bonds and a wealth-destroying -2.3% for long-dated real yields.
Emerging markets have endured a difficult week given the backdrop of a flight to quality. In addition, growing banking sector stress has seen Turkey come under particular pressure.
Corporate spreads and equity markets have also been weaker, as have spreads in the European periphery; though in this context we feel price action is more a reflection of assets being unable to keep up with the strong rally in Bunds and US Treasuries.
Policy pondering in Japan
Elsewhere, as we meet with policymakers in Japan this week, we are intrigued by the notion of Japan in the position of a role model to others. With increased talk of ‘Japanification’ in the eurozone, we are interested by the notion that new policy initiatives are being considered in Tokyo. Notably, there is some thought that a hike in interest rates back to 0% could represent more of a monetary easing than a tightening (tiering of deposits is, de facto, an acknowledgement of this). Speculation of debt monetisation and fiscal easing are also debated in the knowledge that policymakers need to have options at their disposal, lest that fuel a crisis of confidence if it appears they are out of ammunition.
When we reflect on markets from a distance, we would observe that there have been times in the past when we have tended to believe that market pricing is irrational – the most recent example of this was when Italian bond spreads escalated towards 350bps amidst ‘Italexit’ risks at the end of last year. We believe that we are currently witnessing a similarly irrational overshoot as we see US recession risk as mis-priced.
Trump's intent to install one of his acolytes on the FOMC board may be viewed by some as a reason to look for the Federal Reserve (Fed) to cut rates, yet we believe that the FOMC will push back hard, in view of asserting its operational independence. In the same way, the Fed doesn't just exist to deliver policy that confirms market pricing. Ultimately, we believe that the data will lead the Fed and that the Fed will lead the market, not the other way around – save in the case of a very severe market dislocation, which threatens the growth mandate and financial stability.
Mind you, I suppose it is always worth remembering that there are plenty of folk out there who believe the earth is flat...and it seems their numbers have been on the rise recently. You have to hope that those planning to journey to Antarctica don't fall off the edge!