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The impact of the Fed’s monetary tightening will be decisive for the markets

The economic environment has shifted since the start of the year:

  • Global growth has slowed, is less equal and is driven mainly by the United States. The US economy is in "a great shape": +4.2% growth in the second quarter (the strongest increase in three years), robust manufacturing index, highest consumer confidence, historically low unemployment, strong job creation, stock market records . On the other hand, in most other developed countries, we are seeing a slowdown and growth prospects have also been revised downward.
  • The risks have risen: trade tensions, Brexit-related negotiations, uncertainties on Italian fiscal policy and pressures on the currencies of emerging countries whose economic fundamentals are weakening.

 

Against this backdrop, investors have changed their monetary policy expectations:

  • More confidence in the Fed's ability to raise rates. An 80% probability of four Fed rate hikes was being priced in as of mid-September, up from almost 0% one year ago.
  • More questioning and doubt about the ECB's first rate hike. The market does not anticipate a rate hike before early 2020: very moderate inflation expectations coupled with the ECB strong forward guidance (interest rates "at their present levels at least through the summer of 2019"). Mario Draghi explained that "the risks associated with the rise in protectionism, emerging market vulnerabilities and financial market volatility have gained momentum recently".
  • Meanwhile, most central banks in emerging economies have tightened their monetary policies to defend their currencies.

 

Consequences on the bond market:

  • Record spreads between German and US rates (especially on the short end of the curve), reflecting differences in terms of monetary policy expectations. In the coming months, these spreads could be reduced if the ECB scenario of sustained inflation recovery is confirmed. The ECB is targeting underlying inflation at 1.5% in 2019. It is far from obvious, Eurozone core inflation remains at this stage subdued.
  • Long rates under pressure. Term premium – the extra compensation investors demand to hold long maturities- has dropped to historically low levels. "The most recent decline in term premiums, both in the United States and the euro area, can be attributed in part to the growing uncertainty surrounding the global economic outlook, due in part to the escalation of trade disputes. This may have affected confidence among investors and contributed to an increase in demand for US Treasuries and German government bonds, widening the negative term premia that also reflected the stock effect of large-scale asset purchases." (source: ECB). US Fed rate hikes and trade tensions will continue to weigh on emerging markets and strengthen demand for US assets.
  • A spike in spreads between Italy and Germany. We could expect a positive outcome in the short term with the publication of a budget deficit in line with European Union rules. However, the long-term issues remain unchanged: huge sovereign debt, weak growth and the holding of sovereign debt by Italian banks.

 

The protectionist threat and rising political risk will continue to weigh on markets, but global growth should be able to weather these risks. In that context, interest rates should increase but in a limited way. We expect the game changer for the markets to be the US economic growth cycle and the global liquidity cycle.

 

2018-09-25 - Market expectations for FOMC rate hikes

 

AINOUZ Valentine , CFA, Credit Strategy
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The impact of the Fed’s monetary tightening will be decisive for the markets
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