“Nine years of quantitative easing is slowly drawing to an end. The Fed will start to shrink its balance sheet before year-end, while the ECB is set to announce plans for tapering and BOJ purchases have slowed.”
– Vasu Menon, Senior Investment Strategist, Wealth Management Singapore, OCBC Bank
- The U.S. economic recovery remains on track, but the lack of inflation threatens to cause a dilemma for the Federal Reserve. The jobless rate is already well-below the Fed’s estimate of full employment, so it has fulfilled half of its mandate. Job growth has been slowing in 2017 – apparently due to a shortage of workers – but is still fast enough to pull the unemployment rate even lower. The Fed’s analysis is that, at some point, tight capacity will lead to higher inflation.
- However, so far prices have been slow to respond. In fact core inflation has even ticked lower in recent months, although this is partly due to technical factors. Some Fed officials are already voicing doubts about the wisdom of further rate hikes if there is no sign of inflation. There are competing explanations for the lack of price pressures. One observable trend is that firms are allowing rising costs to eat into historically high levels of profitability, rather than raise prices.
- It looks premature for the Fed to have a radical re-think of policy, so we continue to expect one more rate hike this year as well as the announcement of balance sheet reduction. Looking into 2018, we expect a gradual normalisation, with one hike every quarter until the rate hits neutral at about 3 per cent. However we recognise this would need to be reassessed if inflation does not respond or if President Trump can find a more dovish candidate to replace Chair Yellen (which looks difficult).
- Later this year, the European Central Bank is likely to respond to the stronger economic performance by setting out plans to taper its asset purchases in 2018. That would leave open the possibility of a rate hike before the end of next year. Meanwhile in Japan, an exit from the current policy still looks some distance away, but asset purchases have slowed since policy shifted to focus on targeting bond yields, rather than raw balance sheet expansion. By the middle of next year, it looks like the expansion of balance sheets of major central banks in developed economies will be over.
- No doubt, bond markets will face headwinds when QE among the major central banks comes to an end. Most credit markets look fully valued at this juncture. We believe this implies future total returns will be more modest than last year, and will be dominated by carry – or the income component – rather than by further spread tightening.
- Valuations on both High Yield and Investment Grade bonds are currently near post Lehman highs. However in an environment of Fed policy normalisation, we believe that coupon/carry will become an increasingly important component of total return. With its higher corporate spread component, High Yield bonds should be somewhat better insulated from the adverse impact of higher rates. Furthermore, High Yield bonds are better positioned to benefit from a – to date – far substantial decline in overall default rates in 2017 versus 2016.
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