Since the start of the year both bond and equity markets have shown a strong performance. Both rallies were fueled by central banks who have adjusted their monetary policy messages to a very dovish tone. As a result, the 10-year US government bond yield dropped below 2.4% in March, which was lower than the yield on 3-month US government bills, effectively an inversion of the yield curve. The previous curve inversion in the US bond market occurred in 2007, just before the start of the financial crisis. Markets and economists are now debating whether the recent curve inversion is signaling a recession or is the result of other factors.
Adjustment of (great) expectations
In the last two quarters, central banks had to lower both their growth and inflation expectations. Especially the ECB had to take an axe to their assumptions, as eurozone growth stalled in the latter part of 2018, driven by export weakness in Germany and weak growth in Italy. Inflation numbers also turned out below expectations, partly due to oil price weakness late last year, while in the US the dollar strength added to soft inflation numbers. Central banks need to assess whether these trends were due to temporary effects or that the economic outlook has deteriorated significantly.
Source: ECB and Federal Reserve, March 2019
Trade, more trade and elections – a permanent political Halloween
A complicating factor for central banks is the mounting uncertainty related to topics such as Brexit, US/China trade negotiations, US trade rhetoric towards other counterparties, Italian deficit worries, etc. Political uncertainty has increased in the last few quarters, weighing on economic growth and probably an important contributor to the major selloff in equities and other risk assets in Q4 2018. Some of the political issues might be solved in coming months or just ignored by financial markets. But the extension of Brexit to the end of October (Halloween) and the ongoing delay in finalizing the trade deal between US and China show that political risks continue to weigh on markets and growth. In our view, central banks have also adjusted their monetary policy to compensate for and act as a buffer against further political volatility.
Yield curve inversion – recession or slowdown
Financial markets have correctly interpreted the recent communication by central banks as dovish. At the same time, we do not think that central banks will completely turn their policy and start cutting rates, as is implied by the US rate curve at the moment. In our view, part of the economic slowdown is due to temporary factors which will dissipate in the second half of this year. We see some early signs of bottoming economic indicators and we also think that some of the political noise will fade.
From a longer term perspective, interest rates will remain at historically low levels due to structural factors such as demographics and low productivity growth. But even including these factors, we think that current market interest rates are too low and can rebound in coming quarters. Towards the end of the year we might even see the Fed debating once again whether to implement another rate hike. As long as the US labor market continues to tighten and economic growth remains near trend, wage and pricing pressures will pick up and require an adjustment of current monetary policy.
In our active funds we remain underweight duration in anticipation of a rebound of interest rates. We also hold overweight asset allocation positions in EMD and High Yield credits, as we think that investors will continue to search for higher yielding investments.