Markets see monetary policy as still benign, or do they?

Strategy: fundamentals and risks deserve more attention

20 Mar 2017

  • A ‘dovish’ rate rise by the Federal Reserve
  • Yield curves flatten despite Fed hike and hawkish sounding ECB
  • Reflation trade questioned
  • Asset allocation: still defensive

Are financial markets having second thoughts? The positive reaction to the US interest-rate rise petered out towards the end of last week, while the updraft from the expected ‘America First’ policies and planned fiscal stimulus – as reflected in the strong outperformance of the US industrials sector versus the broad S&P500 equity index – has mostly faded. In the eurozone, equity sector performance was mixed, with materials and telecoms standing out and energy and financials lagging. The ECB transmitted hawkish signals, but at the same time, core inflation remains weak. Markets welcomed the Dutch election outcome: the anti-EU and anti-immigration PVV did not become the largest political party, as feared, although it did win further seats in parliament and became the second-largest party.


With many investors expecting an upward shift in the FOMC’s median projections of the path of US interest rates in the near term, policymakers’ unchanged course at last week’s rate-setting meeting gave the FOMC’s decision to raise rates by the widely expected 25bp a distinctly dovish feel, in our view. Given the unchanged macroeconomic forecasts accompanying these rate projections, the FOMC is clearly not prejudging an outcome of fiscal policy plans nor does it feel that it is falling behind the curve. It reiterated further rate increases will likely be gradual and indicated that temporary inflation overshoots are not only acceptable, but to be expected.

This may all be well and good for risk assets and long duration positions for now, but there was an equally important message from the Fed: it would likely react to large-scale fiscal stimulus with more rapid rate increases, scrapping the policy of gradualism to prevent a persistent inflation overshoot. But for now, markets are not even fully discounting this and next year’s additional rate rises. If the economy develops as expected by the Fed, interest rates will need to be adjusted higher. If fiscal stimulus is enacted, rates may need to rise by much more.

Is the Bank of Japan really committed to yield curve control and inflation overshoots? Governor Kuroda last week reiterated this was so, noting that if core inflation did approach 1% in the second half of this year, as some in the markets expect, the BoJ would not automatically raise its yield target. He pushed back on the idea that the BoJ would have to raise the target if the Fed continues to increase rates, implicitly putting downward pressure on the Japanese yen.

Last week we noted that the hawkish signals after the ECB left monetary policy unchanged. Nevertheless, listening to ECB officials, there seems to be hardly any consensus on the timing of rate rises and the sequence of ending monetary policy accommodation. Can rates be raised while the ECB is still buying assets under its quantitative easing programme or should the central bank taper QE first? In February, core inflation held at 0.9%, which should be too low for comfort for the ECB, especially as the boost to prices from the euro’s large fall is likely to dissipate, weighing on core goods prices in particular. These are already close to deflation.

The Bank of England meeting did not turn out to be a non-event after all: one policy-setter voted for a rate rise and some others reported that they were close to doing likewise. The market would usually interpret these signals as hawkish, i.e., rates will rise soon. However, it is worth keeping in mind that the key ingredient in favour of a rate rise – rising wages – is absent and that the central banker favouring a rate rise will soon leave. We believe UK rates will rise only when we hear from the BoE governor that he is seriously considering voting that way.


Rising US, European and emerging equity markets would argue in favour of a stronger growth and inflation outlook. But there are clear arguments against the reflation trade: lower oil prices, flatter yield curves and a more defensive sector performance in the markets.

One reason is the uncertainty about fiscal stimulus in the US. Healthcare reform is progressing slowly and was dealt a blow by a report from the Congressional Budget Office. With Democrats opposed to changes, some Republicans concerned about the CBO findings and other Republicans arguing for even deeper reforms, the fate of the proposals is up in the air. Will this impact the tax reform timeline? While expectations for tax reform have been moved back, we think tax reform may still be discussed before the summer and implemented in 2018. However, all this is disappointing after the high expectations of bold changes shortly after the US election.

And of course there is the risk of protectionism. The differing views on free trade of President Trump and German Chancellor Merkel were confirmed at the meeting of G20 finance ministers. With the US pitted against the other 19 countries, commitments to tackling climate change were removed from the final statement. The reiteration of warnings against competitive currency devaluations and disorderly foreign exchange markets should be seen as positive, but the absence of a commitment to keep global trade free and open was clearly negative.

Despite the US rate rise and the hawkish ECB signals, yield curves flattened in the past week, but the changes were small. Also, US two-year yields had already broken out of their recent trading range after a plethora of Fed hints ahead of the rate rise. Furthermore, German two-year yields are still firmly negative. This all argues against reading too much into the flattening, although – importantly – it does go against central bank actions and comments.

We still see monetary policy as positive to neutral for equities. But we think that markets are priced for perfection: stable, but positive growth, modest inflation and low interest rates and yields. We see equities as expensive on current valuation measures. Taking into account our forecasts for growth, inflation, rates and earnings, we are underweight developed equities.


We have gradually moved to a less cautious asset allocation in recent weeks. What our underweights in developed equities, US high-yield corporate bonds and emerging market debt in hard currency have in common is that we think that the high market prices of these asset classes do not properly reflect worsened fundamentals. They include high equity valuations, weakened corporate balance sheets and US dollar, interest-rate and protectionism risks.


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