Q3 2017 Fixed Income Outlook – Stumbling into a policy error?

07 Jul 2017

  • Recent market movements continue to be dominated more by politics and policy than fundamentals and economics.
  • The third quarter of 2017 starts with plenty of political fireworks originating from some of the usual places, and some new ones as well.
  • The US is experiencing a sudden and sharp deceleration in underlying inflation which is putting the Federal Reserve’s (Fed) near-term forecast out of reach.
  • Global growth continues to increase, albeit at a slower and lower level than had previously been assumed.
  • It’s likely that developed central banks may stumble into a policy error if they refuse to follow conventional macro prudential best practice.

As we have said for the last nine months, recent market movements have been dominated more by politics and policy than fundamentals and economics. While the first quarter posed a number of political questions to fret about, the second quarter delivered the conclusions to many of them. The world now has a much more pragmatic view of what the Trump presidency might or might not deliver, and has a much better understanding of the relationship he has with the Republican dominated congress. Also known are the results of a number of elections in the EU that has significantly eased fears of populism, isolationism, and additional “exits”. Some commentators claim that Rutte’s victory in the Netherlands, Macron’s victory in France and the failure of the AfD to gain traction in Germany demonstrates that populist forces are now in retreat, and by extension, that political risks are diminishing in importance for investors. We disagree with that complacent conclusion. We believe that the right lesson to learn from recent events is that public support for political parties and candidates is proving to be extremely fluid – whether it’s Corbyn in the UK, Merkel in Germany, Mélenchon in France or Trump in the United States. In many cases unconventional candidates have been able to outperform expectations by reaching out to people who do not usually vote. We would certainly not rule out the possibility of, say, the Five Star Movement being able to tap into public discontent with the status quo in Italy and dramatically increase its share of the vote in a future election campaign.

To be sure, we start the third quarter with plenty of potential political fireworks originating from some of the usual places and some new ones: UK (Brexit negotiations have finally started and most analysis portends hard-like Brexit outcomes), Japan (elections in parliament which could challenge Abe’s power), Italy, (elections cannot be delayed indefinitely, a migration crisis plus the usual headaches over banks and budgets), North Korea (no descriptors necessary). Despite this, we find that there is finally some data worth analyzing. Of particular interest is how central banks are interpreting this data and how that interpretation might influence the nine year strong cycle of accommodation and financial repression. To the point of the title of this piece however, despite some relief from the noisy political elements, it is entirely likely that developed central banks may stumble into a policy error if they refuse to follow conventional macro prudential best practice.

Markets will have to digest a more hawkish tone from many of the world’s major central banks as we move into the next quarter. The era of ‘whatever it takes’ – in which investors took comfort that bad news was also good given the central bank willingness to unlock more rounds of unconventional monetary easing if needed may soon be coming to an end. The reasons vary from policymaker to policymaker, and from place to place, but some combination of confidence about the growth momentum, optimism that inflation will return, pessimism about whether the inflation target is achievable, and political pressure has contributed to a coordinated shift in central bank rhetoric. The narrative now speaks to a less accommodative stance.

In the United States the key news has been on the inflation front. There has been a sudden and sharp deceleration in underlying inflation, which has put the Fed’s near-term forecast out of reach. Back at the March Federal Open Market Committee (FOMC) meeting, the median projection of FOMC members for core PCE inflation in 2017 fourth quarter was 1.9%. However, a sequence of weak prints has seen the annual inflation rate slide from 1.8% at the start of the year to 1.4% in May, and sent the more hyperactive annualized change in consumer prices over a shorter three month window tumbling from 2.5% in February to 0.3% in May.

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