G3 Rates: Seeking refuge
- Competitive easing has kicked in amongst central banks
- Lower for longer is still the theme
- We are neutral duration given how low rates are
- We have re-centred our G3 rates forecasts
Flight to safety amidst a highly uncertain outlook will keep G3 yields lower for longer. The list of worries has increased in recent months as investors now have to deal with the re-escalation of China-US trade war (after a brief truce), the risks of a hard Brexit, EM stress (largely Argentina) and political uncertainties in Hong Kong. G10 central banks, which are already facing growth moderation, now have to contend with these ongoing headwinds. It is not possible to insure against trade war (or political risks) by easing monetary policy. However, central banks will try to limit the fallout by making financial conditions even looser. Unfortunately, lower rates (or dovish guidance) from any of the G3 central banks tend to have knock-on impact unto other developed market rates as competitive easing gets triggered. With these dynamics reinforcing the lower for longer narrative, we have re-centered our G3 yields forecasts lower. SGD and HKD rates have also been tweaked accordingly.
The Fed and ECB U-turn
Over the course of a year, the Fed and the European Central Bank (ECB) both U-turned (or are about to) on policy. The Fed delivered the first cut in a decade last month and will likely deliver more if financial conditions tighten or trade tensions worsen. Firm US data does not seem to matter at this time as the market focused on downside risks. Urgency for the Fed to deliver more “insurance cuts” is building after the recent tit-for-tat measures between China and the US (see Macro Strategy, 6th August 2019). US equity markets also had a more serious wobble when the RMB crossed 7 versus the USD and the US named China a currency manipulator. Trump may not have direct influence over the Fed. But by ratcheting up trade war rhetoric, the resulting uncertainty would prompt more “insurance cuts.”
The ECB arguably faces greater urgency to ease policy. Aside from an extended period of weak data, inflation expectations (as measured by the EUR 5Y5Y inflation swap) also collapsed to an all-time low in June. Hints of upcoming asset purchases and rate cuts did not manage to lift this estimate much. The downward distortion to EUR rates is acute amid a shortage of German papers and the prospect of the ECB looking to take even more supply off the table supports the case for an extended period of depressed EUR interest rates. Fear of missing out at a time when the total amount of negative yielding debt exceeds USD 15tn is prompting a desperate search for yield in the developed market space. USTs still offer very attractive relative and absolute yields despite the sizable rally over the past year.
Competitive easing across the G10 space may be difficult to avoid. Looser monetary policy stances from the Fed and ECB have already dragged interest rates in the developed world lower. In any case, G10 interest rates tend to be highly correlated and we suspect that each central bank would face the risk that its currency would become inordinately strong if its interest rates become relatively high. Within the G10 space, “high” USD rates have supported the USD. The Bank of Japan (BOJ) faces similar pressures when the yen touched 106 (from 112 in April) versus USD even as 10Y JGB yields crashed below the bottom of the -0.2 to 0.2% policy range. Pressure to embark on deeper negative rates will mount. This feedback loop of seemingly coordinated monetary policy across the G10 space may take some time to play out and may well result in even lower yields from already depressed levels currently. Lower for (even) longer is the theme.
It would probably take a spike in inflation expectations and / or fiscal stimulus from the large economies to arrest the fall in DM yields. The previous global adjustment took place in late-2016 when Trump won the presidential elections. With the market correctly anticipating that Trump’s presidency will widen the US’s fiscal deficit, yields adjusted higher. We think it may be more difficult for the US to repeat this feat. It would probably require the Europeans (especially the surplus economies) to embark on large scale fiscal spending to increase the supply of government papers sufficiently to nudge European government bond (EGB) yields higher. Otherwise, the default would be a grind lower in yields as ECB purchases dominate. Lastly, a cyclical rebound or a thaw in China-US trade tensions could result in a bounce in yields. However, better data appears to be elusive amid an escalation in the trade war.
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