Our general outlook for the rest of 2018 is for continued global growth with low but rising inflation worldwide. In this scenario, major developed market central banks will gradually reduce the extraordinary level of liquidity in financial markets. The main risk to this benign and constructive base case, however, remains an unexpected acceleration in inflation that causes bond yields to spike higher in the US. Bond and equity markets worldwide remain expensive, though less so since a recent correction from a peak in January. Nevertheless, the overvaluation remains a potential risk to our scenario. Another risk which cannot be dismissed relates to Trump’s tariff threats on trade with China and other countries, which may culminate in a wider trade war in which major economies retaliate. We are still at a phase of threats and posturing, and it will likely be some time before any actual action is taken. A serious trade war is not our base case yet, but these trade disputes are serious and need ongoing monitoring. What follows here are our specific expectations for various regions and currencies.
US and global growth slowed slightly from relatively high levels (by recent standards) in Q1, but there is now a divergence between the US – where economic activity is holding up better and inflation is continuing to rise – and Europe and Japan, where inflation remains quite disappointing. Expectations are now for three or four interest-rate increases by the US Federal Reserve (Fed) in 2018, as key Fed governors appear more confident about both GDP growth and rising inflation. The new Chair of the Federal Reserve, Jerome Powell, working with newly appointed New York Fed president John Williams, and vice chair Richard Clarida, is likely to forge a monetary policy not very different than the one in place under chair Janet Yellen. This welcome continuity at the Fed, together with a robust world economy, should keep the possibility of major policy errors more limited and help extend the current long expansion.
The US dollar weakened sharply in January before stabilising over the rest of Q1. Since mid-April, the dollar has rallied by 3.5% on a dollar index (DXY) basis as US 10-year Treasury yields approached and breached the psychologically important 3% level. The recoupling of the dollar with interest-rate differentials after a long period of a lack of correlation was notable and impulsive. The April surge in US Treasury yields and renewed traction on the US dollar were also consistent with the fact that US GDP growth and inflation in Q1, and the prospects for Q2, have now diverged from the GDP growth and inflation surprises in Europe and Japan. Should these short-term divergences continue, the DXY could retrace to its peak of November 2017 (i.e. about 3.5% higher than where it ended April) when the anticipation of US tax cuts boosted economic activity and dollar sentiment.
US Treasury total returns have underperformed US inflation for three consecutive years—a first since 1981. Yields may need to go significantly higher to ensure positive real returns to investors who will soon have to bid on a lot of new supply thanks to bigger US budget deficits. This could happen as a spike, regardless of how slowly and gradually the Fed raises interest rates.
One historical spike of note was when the Fed last went into an easing mode in the summer of 2003, when over a six-week period 10-year Treasury yields shot up by 132bp (from 3.12% on 13 June 2003 to 4.44% on 29 July 2003 and ultimately 4.6% by 3 September 2003), before correcting lower (see Figure 1).
Figure 1: US Treasury yields
Data as at 4 May 2018. Sources: FactSet, BNP Paribas Asset Management.
We could conceivably see a smaller spike at some point should it become obvious that the US economy is not slowing and that inflation will indeed be higher, along with a lot more Treasury supply.
Whereas the ‘boiling the frog’ approach by the Fed, gradual yield increases in Treasuries and continued global growth would generally be negative for the US dollar, a spike in yields would probably be positive in the short term, even if the Fed is not aggressive — especially as other central banks and regions remain sluggish and highly accommodative. The dollar index (DXY) rallied by 7.5% over the summer months of 2003 before resuming a long decline to the end of 2004 as global growth picked up. Similarly, the dollar could resume its decline longer term as the ECB and Bank of Japan approach their tightening cycles and global growth picks up.
Are there still bond vigilantes out there? Or are the US and global economies too weak to sustain a spike in US rates?
ECB President Mario Draghi indicated that the ECB may need to delay the schedule for announcing further plans for ending its quantitative easing (QE) programme until July or perhaps even beyond. This dovish setback is in contrast to the Fed’s steady path of expected tightening, and, coupled with the contrast between US and European data and a continuation of a pull from US rate differentials, gives the euro room to weaken somewhat in the near term. Our longer-term outlook, however, remains for a stronger euro as the ECB’s exit from QE starts to develop later in 2018. The Swedish krone remains relatively cheap and should fare better than the euro over a longer time frame. The British pound may not fare as well as the euro, as negotiations over Brexit are likely to continue to cloud the outlook for most of 2018. We are neutral on the Swiss franc as it has nearly reached the artificial floor level of 1.2 euro/CHF that broke in January 2015.
The Bank of Japan (BOJ) is expected to begin gradually raising the target of 0% yields on 10-year JGBs as its plan for exiting QE takes shape for 2019. Inflation, however, remains far from the bank’s 2% target and the latest data shows another significant setback. Given that the Japanese yen remains quite undervalued (by 20% or more), we would expect it to stay in a wide range of between 105 and 112 per US dollar in the near term and strengthen longer-term toward 100JPY/USD, or even further, as the BOJ starts to modify its policy of pegging 10-year JGB yields near to zero, i.e., applying a yield curve control (YCC) policy. This adjustment to YCC is now expected to come later in 2018 or perhaps maybe only in 2019. The yen will likely continue to perform best during periods of risk aversion in global markets (e.g., when there are fears of a trade war), and poorly in periods where investors are looking for higher-yielding investments and retain their risk appetite. President Abe’s decline in popularity also plays into the possibility of a stronger yen as any changes in leadership in the government or the BOJ could accelerate the BOJ’s exit from the unpopular negative interest rate environment.
With US dollar strength and US long-term yields breaching major thresholds of 3% or higher, we have generally turned more negative on EM currencies in the near term. A further spike in US yields is possible due to the resilience of the US economy and inflation, and in the face of a large supply of Treasuries due to the growing US deficit and the Fed’s reduction of its balance sheet. On a longer-term basis, EM currencies should stabilise and recover when US yields top out and global growth picks up again — which may not happen until later in 2018.