Financial markets were rather stable over the week, getting used to tough geopolitical comments from US President Trump, this time at the UN general meeting. Japanese equities rose by 2%, outperforming other equity markets, thanks to strong trade data (see charts) and the Bank of Japan’s confirmation of its easy monetary policy. We saw a mixed performance on government bonds, mainly moving sideways. Portuguese debt rallied significantly after rating agency S&P upgraded its credit rating. Among commodities, iron ore was the week’s biggest underperformer, down by 12% amid market concerns over elevated inventories and speculators reversing positions ahead of the winter season when steel production typically decreases.
FED, BREXIT, MERKEL’S RE-ELECTION FAIL TO SURPRISE MARKETS
The Federal Reserve announced the well-telegraphed start of its balance sheet reduction process as it progresses towards monetary policy normalisation. The US central bank will progressively stop reinvesting the proceeds from maturing bonds, initially allowing USD 10 billion per month in bonds to run off (USD 6 billion in Treasuries and USD 4 billion in mortgage-backed securities). The announcement barely moved prices with US 10-year bond yields up by about 4bp over the week. The bond offloading will be ramped up slowly to USD 50 billion per month. The effect of this (gradual policy tightening) decision is cushioned by the continued loose monetary policies of other leading central banks, which should help ensure strong demand for ‘safe’ government bonds globally and cap yields.
Fed policymakers still expect to raise official rates one more time before the end of the year and then another three times in 2018. They have apparently decided to look through the temporary ‘data noise’ caused by the extensive damage resulting from recent hurricanes. They highlighted the significance of one-off effects in the recently low inflation numbers. However, in our view, it is difficult to forecast what the Fed will do in the medium term since likely changes in the composition of the FOMC could well alter its future monetary policy. In addition, changes in the US tax code, due to be discussed from this week, could have a noticeable impact on policy.
In her eagerly awaited speech, PM Theresa May said she favoured a smoother Brexit transition deal with continued access to the EU common market until 2021. She did not unveil any specific measures or give any specific figures on the cost of the settlement of the UK’s financial obligations to the EU. The EU’s chief negotiator acknowledged the prime minister’s more ‘constructive’ tone, but market participants heard nothing new. We will keep a close eye on the negotiations with EU as they resume this week.
German elections results gave Chancellor Angela Merkel a renewed majority, but the rise of the far-right AfD to third place and the left-wing SPD dropping out of the grand coalition to become the leading opposition party are worth highlighting. Merkel’s CDU/CSU now faces the prospect of forming a coalition with the environmentalist green party and the liberal, pro-business and less pro-European FDP.
BANK OF ENGLAND: CAUTIOUSLY HAWKISH
In a speech at the IMF, BoE governor Mark Carney confirmed the intention to reduce monetary stimulus if the UK economy develops as forecast, stating that a “static monetary policy stance becomes more expansionary, all else (being) equal”. Accordingly, we expect the central bank to raise rates at the next policy meeting, using the window of opportunity offered by higher inflationary pressure (which we deem temporary) and improved growth.
Carney tempered his hawkish tone by saying that “policy rates can be expected only to rise a limited extent at what can be expected to be a gradual pace, settling at levels significantly below those seen pre-crisis”. He pointed out that “there remain considerable risks to the UK outlook” due to Brexit, but remained confident on the longer-term prospects, describing Brexit as “an example of reculer pour mieux sauter” (taking a step back in order to jump higher).
Positive macroeconomic data appears to have comforted the policy hawks at the BoE. Notably, retail sales surprised to the upside. We still have to pay close attention to the data ahead of the 2 November rate-setting meeting. A negative surprise could change the BoE’s position.
ASSET ALLOCATION: POSITIONED FOR AUSTRALIAN, US YIELD CONVERGENCE
Our new long position on 10-year Australian government bonds versus US Treasuries has benefited from Australian central bank governor Lowe stating that “a rise in global interest rates has no automatic implications for us here in Australia”. Furthermore, the downturn in iron ore prices is positive for Australian bonds, which had come under pressure from higher commodity prices and the improved macroeconomic environment. Currently low US Treasuries had benefited from a dovish Fed stance, but are now more likely to suffer from positive macroeconomic data. Relatively high Australian bond yields would likely feel downward pressure from negative data surprises. Therefore, we are positioned for yield convergence.
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