Will weak inflation hold back rate hikes?

When and how quickly the major central banks will scale back the pace of monetary easing is a significant concern for investors. Fears of rising bond yields and a central bank policy mistake are foremost in investors’ minds, according to a recent Bank of America Merrill Lynch global fund manager survey.

Given these fears, it’s not surprising that markets have been unsettled when it has seemed central banks are preparing to scale back stimulus. A bond market sell-off followed comments on 27 June from ECB President Mario Draghi that “the threat of deflation is gone and reflationary forces are at play.” German 10-year Bund yields, which were 0.25% on 26 June, rose to 0.47% by 30 June and 0.57% by 7 July. The sell-off spilled over into Eurozone equities, and the usual positive correlation between yields and equities turned negative, reaching –0.34 on 12 July (compared with an average positive correlation over the last 7 years of +0.38.)

While we will stay alert for changes in monetary policy, we retain a moderate risk-on stance.

But we believe concerns about both a potential hawkish shift among the major central banks and its potential impact on markets, may be overstated:

1) Recent inflation data has turned out weaker than expected.

US CPI inflation of 1.6% for the 12 months to June was lower than expected for the fourth consecutive month, and CPI has now declined by 1.1 percentage points since February. Similarly in the Eurozone, annual headline consumer price inflation slipped to 1.3% in June, from 1.4% in May and a three-year high of 1.9% in April, while the UK consumer price index unexpectedly slowed to 2.6% in June compared to 2.9% in May.

2) Softer inflation is now feeding a more dovish slant to central bank rhetoric.

Fed Chair Janet Yellen’s Congressional testimony in mid-July and Mario Draghi’s commentary after the July ECB meeting were more dovish in tone than previously. Yellen told Congress that “the federal funds rate would not have to rise all that much further to get to a neutral policy stance.” And with inflation still below the ECB target, Draghi said “we are not there yet,” suggesting no need for rapid policy change.

3) Fears of a “taper tantrum” may be exaggerated.

The market has already priced in a significant proportion of the expected rise in US rates, with 10-year US yields currently at 2.3%, up from 1.43% last December before the first Fed hike in this cycle. The Fed’s estimate is for a relatively low terminal rate of 3% by the end of 2019, with rates only reaching 2.25% by the end of 2018. And with inflation expectations well-anchored – US 10-year breakeven rates are currently 1.78% – this suggests there is little fundamental justification for a further sharp upward move in 10-year bond yields.

Lower-than-expected inflation data in the US, Eurozone, and UK have given policymakers less reason to withdraw monetary accommodation quickly, or sharply. This has reinforced our view that central banks should continue to be in a position to provide a high level of monetary accommodation.

So, while we will stay alert for changes in monetary policy, we retain a moderate risk-on stance, with an overweight position in global equities. While we expect inflation to gradually go on rising, we believe that bond yields and borrowing costs will only increase moderately from current levels. We forecast US 10-year yields to be around 2.5% in 12 months, compared with 2.3% at present and German 10-year yields to be around 0.6% in 12 month, compared with 0.53% at present.

Bottom line

Central banks are in no rush to withdraw monetary accommodation, and recent weaker inflation reduces the need to move faster. We therefore believe that bond yields will not rise much further than current levels over the next 12 months. This supports our moderate risk-on stance, with an overweight position in global equities.

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