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In the song of ice and fire, fire always wins

The Fed faces a stark choice…

At this week’s Federal Reserve (Fed) meeting, Chair Powell outlined a landscape in which US economic growth burned brightly, even as inflationary pressures seem to be stuck in deep freeze.

These conditions appear to allow the FOMC to maintain rates on hold for the foreseeable future and this points to a constructive backdrop for financial markets in the weeks to come.

Treasury yields moved somewhat higher in the wake of the meeting, as market speculation – hoping for the Fed to bend to President Trump’s wishes for lower interest rates – was played down by the central bank.

Powell appeared at pains to highlight that conditions could evolve to merit either a rate hike or a rate cut as the next monetary policy move, with the Fed in ‘data dependent’ mode.

This appears relatively sensible and pragmatic policy making, in our opinion. Indeed, although inflation is below target, we believe there would be a risk to economic and financial market stability were the Fed to cut rates into an economy that continues to enjoy growth at an above-trend rate of 3% on an annualised basis.

Eurozone enjoys relative data brightness

In Europe, better-than-expected GDP data helped alleviate concerns with respect to the forward-looking outlook. Although the eurozone continues to underperform, relatively speaking, real economy data has been better than prior survey expectations.

Growth in jobs and wages has helped to support domestic demand, though we continue to expect the ECB to maintain a dovish outlook to policy, with core inflation remaining well below target.

Affirmation of the Italian credit rating at BBB by S&P helped BTPs recover losses from last week. Meanwhile, a benign outcome in the Spanish elections, with PSOE scoring major gains and a relatively muted showing for the nationalist party, Vox, also saw Bonos rally during the week.

We continue to project further compression in eurozone sovereign spreads and doubt the upcoming EU Parliamentary elections will be viewed as a significant risk event.

With ECB rates stuck for an indeterminable period, flatter curves and tighter spreads would seem the likely follow-on from a search for yield, especially if volatility remains subdued.

Chinese bounce doesn’t eliminate deleveraging theme

With Japan on Golden Week holidays for two weeks following the Emperor’s succession, Asian markets have seemed relatively quiet over the past few days.

Better PMI data in Korea appeared to confirm the trend towards better second-quarter activity data in the global economy, although China figures slipped.

This suggests to us that the recent Chinese bounce is unlikely to deliver a sharp and sustained acceleration in GDP, given that the theme of deleveraging the economy has not gone away altogether.

Argentina and Turkey taunt EM

Meanwhile, sentiment in emerging markets (EM) continues to be coloured by weakness in Argentina. Short-dated CDS spreads reached a high of 2,000bps last week before correcting tighter, but with Cristina Kirchner doing better than expected in the opinion polls, as the economy continues to flounder, nervousness remains elevated with Argentina assets remaining something of a consensus long risk position on the part of many global investors.

Turkey also remained under pressure with the lira approaching 6.00 versus the US dollar. Other EM currencies were also overshadowed by a firm tone in the dollar, supported by ongoing US economic outperformance.

A soft time for returns?

As we move into May, we would observe that this time of the year has witnessed a disproportionate number of risk-off events in the last few years. From the 2013 taper tantrum to last year’s sell-off in EM or widening in BTP spreads, May and June have tended to witness soft returns at a time of year when the supply of corporate bonds tends to be heavy.

However, when we survey the investment backdrop in 2019, it strikes us that overall risk positioning remains relatively conservative and, unlike past years, we don’t see many obvious risk events which could derail markets in the very short term.

The ultimate battle: Fiery growth versus chilling inflation

Looking further ahead, when we assess the outlook for the US economy it seems appropriate to debate whether, in the battle between a hot economy or cold inflation, whether the Fed will decide to hike or to cut as its next policy move. Ultimately, it is our conviction that strong growth, powered by the US consumer, will see wages rise as unemployment falls.

Rising employment, rising wages, falling taxes and strong consumer balance sheets all underpin the outlook for strong consumer demand and we see personal consumption expenditure likely to rebound strongly in the second quarter after modest growth in Q1 GDP data.

Consequently, with services price inflation already at 3%, we continue to look for inflation to move back above the Fed target as cyclical price pressures start to gain traction over structural factors, which have been pushing prices the other way. In that case, we see growth winning this battle.

Consequently, we continue to believe that a rate hike is more likely than a rate cut in the year ahead, even though we acknowledge that traction on prices will need to be seen before this can likely occur.

Our thinking remains in contrast to easing expectations embedded into futures market pricing and so we continue to run duration risk on the short side in US rates, notwithstanding that this view has been strongly challenged in past months.

Ultimately, we retain conviction that the Fed will face Arya(l) Stark choice. In this struggle between fire and ice, we see fire winning the battle.