Weekly Market Focus

Lower for longer is not the same as low forever

Johan Jooste
Chief Investment Officer
Bank of Singapore
Member of OCBC Wealth Panel

The overall backdrop of good global growth remains the single most important factor to expect rates to be headed higher. We view the pace of growth as moderating from Q2 2017; this does not mean that a recession is brewing in the near term or that markets should be complacent about central banks remaining on dovish settings indefinitely. Lower for longer is not the same as low forever. At some point monetary policy will normalize.

U.S. Rates
An interesting development in the U.S. over the last month was the mooted extension of the issuance programme into the ultra-long area. The idea was floated that bonds dated 50 years or even 100 years should be added to the issuance schedule. This would not be entirely unheard of. In Europe this has been done (out to 50 years), and some years ago Mexico printed a 100-year maturity bond.

After the first round of consultations, the idea was politely rejected. Market participants expressed limited interest in bonds of that length. Given the absence of natural demand for such long-duration bonds, a more likely course of action would be for the Treasury to re-introduce the 20 Year bond and shelve any experiment in making the curve longer than it is already.

After a weak Q1 in GDP terms, the market may have been tempted to read some moderation in the pace of Fed hikes. This is premature, and the payrolls data suggested why. The labour market continues to tighten, even if wage growth has been slightly softer than could have been the case. The Fed is almost certainly going to hike at its June meeting, and there is very little to suggest that it will be the last time for 2017.

Looking out further, there is still the risk that the market is too complacent about the Fed’s intentions. The dot plot shown here shows that the market is still expecting the Fed to undershoot its stated intentions. It has been the correct strategy to date, but may not be so for 2018. Despite our views on a moderating cycle, there is enough inflationary pressure in the pipeline to keep the Fed on course for more than two hikes in 2018. Our view remains for four.

The market seems to have taken the Fed signalling that it running down its balance sheet from the end of the year as an indication that interest rates will not need to rise as much as suggested in the “dot chart”. However, the balance sheet discussion took place in the same policy meeting that produced the dot chart. It is not a choice of either raising rates or shrinking the balance sheet – the Fed intends to do both.

Snap elections in the UK won’t alter the view
The calling of elections by Mrs May is not likely to play into the UK curve view in any meaningful way. The key issues facing the Bank of England remain the same. The outcome of the election is not in any doubt right now. The strong showing by the Conservatives in the recent local elections point to a majority for the Tories of around 100 seats. Not since the days of Mrs Thatcher was the majority this large. For Brexit and the UK economy, it is not all that relevant.

If anything, the united front being portrayed by Europe in its view of how to deal with Brexit is growing stronger not weaker. The UK still has some clarification to do in its own stance, and we remain of the view that the economic consequences for the UK will not be positive. A bigger majority for the Tories does not alter this dynamic.

More to the point, the UK economy faces a stiffer inflation challenge than other major markets after the decline of the currency post-Brexit. The gilts market is still quite sanguine about inflation, perhaps factoring in some of the headwinds facing growth. We noted in last month’s report some of the issues facing consumers in the UK; here we can add that there is now evidence too of tightening credit conditions to go with the pressure on consumer spending due to wage growth’s failure to outpace price increases.

Still, with an election looming, it would be odd for the MPC to change tack now and adopt a more hawkish tone. A more patient line will be followed for now. The risk of course that once the election is out of the way things will change. Inflation at 3% is a distinct possibility (see the markets’ view in chart below), and with policy settings still unadjusted after the emergency loosening after Brexit, we expect the MPC to become cautious in its outlook in the second half of the year. At the short end and the long end rates will have an upward bias.

Euro Area: Restless politics does not alter the rates view
In Europe, there is potentially more room for political surprises than elsewhere, but we take the view that for the most part this will have little to no impact on how we view interest rates for the rest of the year. Here too we leave our previous forecast unchanged.

The main point of discussion in the market is the ECB’s plans for a normalization of policy over the next several years. First, at the June meeting coming up, it can be expected that the statements following the meeting will reflect a view that the downside risks to growth have abated to an acceptable level. If delivered, such a statement would be in line with our reading of the situation as well, namely that European growth is doing just fine.

After that, however, the path will be one of slow and steady steps forward. Simply put, if the underlying inflation risk remains as muted as it is now, the risk to falling behind the curve remains very low indeed, and the ECB can afford to play the long game.

At or around the September meeting talk will begin to focus on a plan to reduce the pace of QE purchases. This will only be implemented in 2018, and precisely when remains an open question. It is likely that the ECB will view the matter mostly as a data-dependent question. That is to say, it will let itself be driven more by inflation and growth developments rather than a pre-determined timetable.

In the context of ECB tapering it is worth mentioning that the ECB is potentially facing issuer scarcity constraints in Germany in implementing its asset purchasing programme. To compensate it will be shifting focus to France and Italy in the first instance.