Tanguy Le Saout, Head of European Fixed Income
Central Bankers Start Talking Again:
Whilst August is traditionally a quiet month in markets with many participants on vacation, central bankers have been quite active in trying to guide markets to their way of thinking. In the U.S., San Francisco Federal Reserve President John Williams started his August 15th Economic Letter by stating that “the time has come to critically reassess prevailing policy frameworks and consider adjustments to handle new challenges, specifically those related to a low natural rate of interest”. That’s central banker code for saying “governments need to do more on the fiscal side and we need a new way to think about monetary policy”. Shortly afterwards the minutes of the July U.S. Fed meeting were published, showing a divided committee. Some members thought that the economy was sufficiently strong to weather a rate increase, others felt that they would prefer to wait for inflation to move higher before moving. Across in Europe, the minutes of the ECB’s July meeting showed that the fall-out from the Brexit vote in the UK “has thus far been less marked than many had anticipated”. Once again, the ECB noted that they stood ready to take whatever actions were necessary to reach their 2% inflation target, but repeated their mantra that Eurozone governments needed to help as well, preferably by enacting structural reforms. In the UK, speculation is mounting that the new Prime Minister Teresa May could announce a fiscal stimulus package that, along with the Bank of England’s (BoE) recent monetary stimulus measures, might help the UK economy weather the fall-out from the Brexit vote. Finally, in Japan, Prime Minister Shinzo Abe launched a new 4.6trn Japanese Yen (U.S. $45bn) stimulus package to boost a struggling Japanese economy. All this suggests that global governments are moving closer to acknowledging that central banks and Quantitative Easing (QE) programmes alone cannot solve the world’s problems. With long-term interest rates at historically low levels, it makes sense, in our opinion, to loosen the purse strings and boost fiscal spending, financed by issuing long-dated bonds (as Japan is considering doing). In the medium-term, this could lead to higher bond yields and steeper yield curves.
Did Brexit Really Happen?
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Looking at the current levels of markets in the UK, you’d be forgiven for thinking that the UK had never voted to leave the EU. UK equity markets are between 5%-10% higher than on June 22nd, and gilt yields are substantially lower. In fact, the UK 10-year gilt yield was 1.37% on June 23rd and is now 0.52%. The spread between 10-year UK yields and 10-year German yields has almost halved – from a spread of 128bps to its current level of 65bps. But the gold medal in the bond Olympics goes to the UK 30-year, which has enjoyed a total return of 35.6% since the start of the year. That begs the question – is such performance justified? The consensus post the referendum vote was that the UK would experience a significant slowing in economic growth, and possibly even fall into recession. But so far the data hasn’t been as bad as feared – UK retail sales for July were up +1.5% versus the previous month, and are +5.4% higher than this time last year. In truth, we haven’t had a lot of economic releases to indicate how economic activity fared post the Brexit vote, but what we have seen so far suggests a smaller fall-out than initially expected. The BoE did act aggressively in early August – cutting rates by 25bps and increasing their QE programme by £60bn per month for the next 6 months. The QE announcement was greeted with delight by the gilt market, and was mainly responsible for the aforementioned rally in gilt yields. However, the size of the extra QE from the BoE is smaller in flow terms relative to the size of the nominal government bond market that in Europe or Japan. Looking at it another way, UK 10-year real yields have fallen by 25bps since the BoE’s announcement, whereas U.S. 10-year real yields have risen by 5bps. The final thing to bear in mind is the substantial fall in Sterling – the trade-weighted exchange rate has fallen 21% in 2016. In our opinion that will eventually feed into higher UK inflation, making UK gilts look less attractive. We believe that a neutral duration stance in UK gilts is warranted.
European Inflation – What’s Happening?
In our last blog before the summer vacation, we noted that European inflation expectations were no longer tracking the oil price (with which they previously had a reasonably strong correlation), but now appeared to be more correlated with European bank stocks. The attached chart shows the updated relationship. Although the oil price is technically back in a bull market, having appreciated by over 20% from its lows on August 2nd, it has had little impact on Euro-area inflation expectations. The gap has been wide before (most recently in June 2016) but it does have a habit of mean-reverting, and the current gap in our opinion is wide enough to suggest that there will be convergence shortly. But the more relevant question might be why inflation expectations have not tracked the oil price recovery. One theory is that inflation-protected issuance in Europe picks up in September as sovereign issuance programmes restart after the summer break, and investors don’t wish to push the price of inflation-protected securities higher before that issuance. But more likely in our opinion is the view that investors have bought into the “low inflation forever” story, especially as economic growth is still struggling to reach the levels seen before the global financial crisis erupted in 2008. However, whilst we don’t expect to see inflation recover to target levels anytime soon, we do believe that there are grounds to expect inflation to move higher over the next 6 months or so. The falls in the oil price of 12 months ago will soon start to fall out of inflation calculations, to be replaced by more recent oil price increases, which will have the effect of automatically pushing inflation higher. In our opinion, the market isn’t priced for such an outcome, so an increased allocation to inflation-protected securities might be a good idea during the coming months.
Source: Bloomberg, Pioneer Investments. Data as of 19 August 2016.