Seen as more dovish, Janet Yellen shifts focus to below-target inflation

European equities favoured despite euro strength

17 Jul 2017

  • US Fed surprises with dovish tone
  • Crude oil: starting to rebound?

Risk markets were cautious as bond yields generally ground higher early last week. However, a speech by Janet Yellen, chair of the US Federal Reserve, helped stabilise bond markets and provided a catalyst for US equities to rally along with commodities as the US dollar softened on the foreign exchanges. After the euphoria around Yellen’s comments, seen as striking a dovish note on monetary policy, European equities struggled in the face of a stronger euro.


Fed Chair Yellen, delivering testimony to the US Congress, had been expected to stick to her guns with a hawkish policy stance in line with comments made last month in which she seemed to turn a blind eye on weak inflation figures and signalled that policy normalisation would continue. However, she surprised with a more dovish tone, acknowledging that “inflation has been running under (the Fed’s) 2% objective, [and] that there could be more going on there.” As pointed out in the fifth Beige Book – a regional economic survey release by the Fed – wages only increased at a ‘modest to moderate pace.’ Wage pressure is typically a key element on fuelling sustained inflation. The report also highlighted the continued tightening of the job market, especially in the construction and IT sectors, taking the employment rate to close to a 16-year low at 4.4% and leaving the country with a shortage of qualified workers.

Yellen’s speech contrasted with recent debates at the European central bankers’ forum in Sintra, Portugal. Indeed, ignoring official inflation targets and instead focusing more on rising financial asset prices was one of the main takeaways from the ECB forum. Yellen’s speech has swung the focus back to more traditional concerns about inflation targeting. Alternatively, her dovish tone may have been a precaution to avoid what has been seen as miscommunication by ECB President Draghi, whose hawkish tone had triggered a bond sell-off in Europe. The ECB was later forced to adjust Draghi’s message and smooth its hawkish tone. While Yellen was cautious on inflation, she also reiterated the Fed’s commitment to policy normalisation and to trimming its crisis-era QE-inflated balance sheet starting ‘this year’.

Confirming Yellen’s concern, the latest US inflation data disappointed again. Year-on-year core inflation was 1.7% in June, extending the downward trend since the 2.3% peak this February. Except for January, the core inflation surprise index – reflecting the difference between survey data and the official release – has not been positive since last August.



Crude oil prices had a positive week with supportive inventory figures on the back of sustained demand. However, we expect this rally to be short-lived for several reasons. First, on the supply side, US shale producers are acting as a cap to any upside for prices, pumping more oil as prices rise, while at the same time, improving technology (e.g., better drilling heads, data management) is driving down breakeven prices, allowing for profitable production at a lower cost. Second, the ability of the OPEC producer cartel to sustain prices through production cuts appears to be reaching its limits. The latest International Energy Agency figures showed OPEC member compliance with production quotas had decreased.

n part, this could be due to the pressure that production cuts are putting on the fiscal balances of the main OPEC producers, including Saudi Arabia. Indeed, the cuts are hurting their revenues without having the expected impact on oil prices: despite the current agreement on production cuts, spot prices have remained relatively low and on the forward market, future contracts are trading at above spot prices, benefiting those US shale producers who hedge their production by selling oil a few years forward. Arab Gulf countries typically sell their production at spot prices. Looking at the forward market curve, one can see that the OPEC cut had an impact in January, but this has now been reversed, with the curve now similar to where it was a year ago. This could raise doubts about the efficiency of a production cut and keep OPEC countries from renewing the agreement. Instead, a battle for market share could flare up involving the ‘opening of the taps’ and raising production.


On the fixed-income side, we are maintaining our tactical short EMU duration position since we expect a correction, with yields falling back again. In the longer run, however, we believe a short duration strategy remains sensible, also because the negative net supply of quality bonds should add a scarcity premium to prices and increase the downward pressure on yields.

As for our other strategies, we regard US equities as more overvalued than European ones. We are overweight eurozone equities versus US and UK equities. This also reflects the fact that our forecasts for UK equities are much lower than the consensus expectations.

On real estate, European stocks have rallied significantly this year, while US real estate has lagged, encouraging us to overweight US real estate since we expect this divergence to reverse over the coming months amid growing demand and limited supply in the US.

We do not believe high-yield bond markets have adjusted enough to the recent drop in oil prices and the risk of rising default rates in the US energy sector, while in emerging markets, we prefer local currency debt, which should allow us to benefit as emerging currencies appreciate.

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