The last year has seen a dramatic shift in the outlook for global monetary policy. Although yields have already fallen sharply, US bonds still appear to offer value given the darkening economic storm clouds, argues Peter Fitzgerald.
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Central banks around the world have been flagging looser monetary policy with economic conditions weakening as the damaging trade war between the US and China weighs ever more heavily on business confidence. Although the two economic superpowers struck a truce at the G20 summit in Osaka, Japan in early July, that has failed to allay concerns the global economy could be heading for recession next year, particularly if other countries are dragged into the conflict.
It all seemed so different last autumn, when growing numbers of central banks appeared poised to join the US Federal Reserve (Fed) in gradually removing the monetary policy punch bowl. Now, however, the prospect is suddenly for easier, not tighter, policy almost everywhere, including the US.
This rapid 180-degree turn in the monetary policy outlook has been driven by a material weakening in the global economic backdrop, which prompted the World Bank in June to cut its global economic growth forecast for 2019 to 2.6 per cent from three per cent six months earlier. It warned the risks to this forecast were largely to the downside.
While evidence of a slowdown in the all-important US economy has to date been patchy, President Donald Trump’s efforts to wage war on trade with China and others has begun to take a toll on business confidence. With inflation now seen falling even further below its two per cent target in 2019 than the Fed had until recently expected, US policymakers have begun to signal they are ready to lower interest rates for the first time since 2008.
Significantly, the central bank recently dropped a reference to being “patient” on borrowing costs since “uncertainties” had increased the case for a cut. US money markets reckon the Fed will be forced into slashing its main policy rate by between 75 and 100 basis points over the next twelve months.
Other central banks have turned equally dovish. Most strikingly, European Central Bank (ECB) President Mario Draghi warned recently that “in the absence of further improvement… additional stimulus will be required”.
Having hoped this time last year to deliver at least one rate hike while he was still at the central bank’s helm – Draghi steps down this autumn – his comments suggest the ECB has gone beyond standing ready to offset downside risks if they materialise and is now committed to further stimulus if the outlook does not improve. This represents quite a turnaround in its intentions. Rate cuts, a fresh round of quantitative easing, or a combination of the two, appear to be in the offing.
Of course, the ECB, like the Bank of Japan, has far less scope to loosen policy since rates are still stuck at record lows. This is a big concern. Although both central banks are understandably keen to dispel the idea they are out of ammunition, it is far from clear how effective a fresh round of quantitative easing would be, should either economy slide back into recession.
While the US and China may have called a truce in their trade war for now, the dispute seems likely to intensify over the medium to long term. Not only is neither side in a hurry to back down for fear of loss of face, the trade war is already morphing into a new cold war with technology taking centre stage.
Worse still, Trump appears to be hell bent on opening up other fronts in his trade battles. On July 1, the US proposed new tariffs on EU goods worth $4 billion as it stepped up its fight over aircraft subsidies. The 89 products, which include meat, cheese, pasta, and whiskey, could be added to a list of EU exports worth $21 billion the US said in April would be subject to tariffs.
The International Monetary Fund said on June 6 the US economy, which is already coming off a sugar high from last year’s huge tax cuts, could face “material risks” if Trump continues to aggravate trade disputes, with repercussions that may spill over to the rest of the world. The fact US public finances are on an “unsustainable path” magnified those risks, it added.
Against this backdrop, government bond yields have plummeted. Having reached a seven-and-a-half-year high of 3.23 per cent last October, ten-year US government bond yields on June 25 dipped below two per cent, a two-and-a-half-year low. On the same day, German ten-year bund yields fell to a record low of -0.3 per cent, while French yields turned negative for the first time.
Although they have already fallen a long way, the worsening economic backdrop means yields may have further to fall. That is especially true of the US since the Fed has more scope to lower short-term rates than other central banks. Even if US rates don’t fall as far as anticipated, 30-year US Treasuries look undervalued with yields at 2.5 per cent compared with a measly 0.2 per cent yield offered by comparable German government bonds.
As for other investment markets, there looks to be some value in selective hard-currency emerging debt markets. While investing in such assets is not without risks, many bonds are offering an attractive pick-up in yield relative to US Treasuries.
European subordinated financial debt also looks attractive. European financial institutions continue to strengthen their balance sheets, which has left this type of debt undervalued relative to more senior bank debt. It also looks cheap relative to non-financial corporate debt since the balance sheets of non-financial companies, in contrast to those of banks, are becoming increasingly stretched. That is especially worrying with the economic outlook deteriorating.
It was a precipitous drop in equities last autumn that prompted the Fed to halt monetary policy tightening. While the US equity market is once again setting new highs, this is largely because the market is being supported by expectations those rate cuts will come through. The current rally in equity prices is no reason to believe the Fed will turn hawkish once again, which would risk a major sell-off. Nonetheless, although we are broadly neutral on equities, we are looking to sell into strength given our concern over the economic outlook and the extent of the recovery in prices seen so far this year.
At the present juncture, we believe Italian government bonds represent a better way to add risk to our portfolios. With ten-year BTPs yielding 200 basis points over bunds, spreads could narrow appreciably should the prospect of easier monetary policy start to lift the economic storm clouds. At the same time, investors are being offered a sizeable cushion in the event the economic backdrop continues to deteriorate.
Elsewhere, worries the US-China trade war will intensify, potentially ensnaring other nations, means we are cautious on several Asian economies and their currencies, in particular low-yielding ones such as the South Korean won, and Taiwan and Singapore dollars.
This article originally appeared on FE Trustnet.