Global Weekly: The U-turn of central banks

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In the last week of March, yields continued to fall as both investors and central banks seem to worry that Europe’s economic future increasingly looks like Japan’s recent history of slow-to-no-growth and inflation.

Another round of disappointing business confidence indicators, mostly (but not only) in Europe, reinforced this notion. Meanwhile, the Fed is leading most central banks in a fundamental rethink of their policy framework, as this is challenged by stubbornly low inflation. This increasingly questions the banks’ view on how inflation dynamics work in today’s global economy. Inflation expectations fell again last week and are much lower than three months ago. Central banks are increasingly worried that low inflation expectations become a self-fulfilling prophecy and are struggling to cope with this.

Meanwhile, the ECB continues to prepare markets for the possibility of a low-for-ever instead of a low-for-longer rate policy. The ECB is aware that it may be too late to hike in this cycle. It is for example currently looking into possibilities to mitigate the drag of negative policy rates on banks’ profitability. Under these circumstances, it was no surprise that 10-year Bund yields fell below zero again, as they did in the summer of 2016.

The Fed already communicated a shift to a looser policy and markets may now be overreacting a bit. The combination of lower global yields, mixed signals from the US economy and a structural accommodative shift by the Fed has now pushed 10-year US Treasury yields below 3-month yields for the first time in a decade.

The five times this happened before, a recession followed within one or two years. This is why the inversion of the US yield curve was clearly noted by investors and policymakers, even though there is no guarantee or even robust statistical significance to these few observations. We continue to think that the risk of a recession within 12 months is relatively low, although recent data tilted the risks to our outlook to the downside again.

Spreads moved mostly sideways, torn between disappointing macro data and the prospect of central bank support. We expect a moderate improvement in economic data over the next few months to confirm trend-like growth in the second half of this year, not a recession. The improved data should allow spreads to move sideways and corporate bond investors to earn yields on their positions.

High-yield bonds have managed to keep up with the rebound of emerging-market bonds this year so far. High-yield bonds, however, look clearly more vulnerable to downside risk scenarios. Relatively strong performance of high-yield bonds has only added to arguments for investors to overweight emerging-market bonds versus high-yield bonds, as we are still recommending.

Stocks: Some clouds

As the first quarter draws to a close, global equity markets have been rebounding nicely across all regions and have almost recovered year-end losses, in an environment of slowing global economy and a sharp deterioration in earnings momentum. However, investors’ optimism may face some clouds.

The main drivers behind the rebound were falling interest rates, more accommodative central banks and progress on trade talks between the US and China. Last week, however, the German manufacturing PMI index, an important confidence indicator, dropped to 44.7 in March from 47.6 in February and also the US yield curve inverted, when the US 10-year yields fell below the 3-month yields. This kind of poor economic releases in Germany coupled with the inverted US yield curve may have shaken investors’ optimism, by casting doubts on the amplitude of the economic slowdown.

A yield curve inversion has often been considered a forward indicator of a recession in the coming fifteen months. However, this indicator has not always been 100% accurate and the inversion has to last several months to be considered a strong signal. Moreover, its influence on equity markets’ behaviour should not be overstated: History suggests that 50% of the time, US equity markets managed to extend gains in the months following a yield curve inversion.

Heading into April, the market will focus its attention on corporate first-quarter results and outlook. This should be a useful indicator to determine the future market direction. In fact, most of the consensus numbers are pricing an earnings recession for the first quarter of 2019 (-1% according to Bloomberg) with a strong reacceleration in the fourth quarter of the year. Should the consensus prove to be overly pessimistic, this would give some fuel for the equity market rebound to continue.