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Fixed income, rates, currencies: Global economic discomfort

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  • Fed’s wait-and-see approach to monetary policy adds to contradictary signals
  • China’s economic slowdown is continuing despite an easing of trade war tensions
  • Growth in Europe has been weakening

Central bank doves are gathering in 2019, with the Federal Reserve’s shift to a more accommodative stance perhaps being the most noteworthy addition to the flock. Certainly the tenor of the Fed’s announcement caught markets by surprise and while that shock wave was being assimilated, there then followed some relatively upbeat US economic data. 

The Fed’s new ‘patient wait-and-see’ approach to monetary policy is its acknowledgement of the “somewhat contradictory picture of generally strong US macroeconomic performance alongside growing evidence of cross-currents”. While good to know that the Fed is cautious and keen to avoid policy mistakes, it does little to ease the discomfiting feelings about the ongoing economic contradictions.

Although trade tensions might have eased, China’s economic momentum is still weak. The Fed’s pause in tightening further enables the People’s Bank of China to carry on with its own monetary easing, which has been quite aggressive so far. Policymakers will also enact significant fiscal measures, in the form of lower taxes and higher special local government bond issuance. The risks to economic growth, however, do seem more skewed to the downside, particularly given the current low level of trade tensions.  

In posting consecutive quarterly GDP contractions, Italy has entered into a technical recession and, after January’s disappointing Purchasing Manager index figures, it looks like Italy’s economic weakness has continued into 2019. 

Although Italy is not alone in Europe in posting weaker growth in more recent months, Italian real GDP (that is, adjusted for inflation) per head has stagnated since 2000, markedly underperforming the other periphery economies of Greece, Portugal and Spain. The contrast with the latter is particularly stark with the Spanish economy to growing throughout most of 2018 and unemployment continuing to fall.

italian manufacturing pmi

Bonds

On the day of the Fed’s dovish deliverance, the US Treasury announced that it would, for the first time since 2012, increase the supply of Treasury Inflation-Protected Securities (TIPS), although by less than markets had been forecasting.

As might be expected from the presence of two strong tailwinds, in the form of a less hawkish Fed and less supply, TIPS did join in the rates rally’s response to the monetary policy meeting, with 10-year real yields falling nearly 20bps that week. 

Unsurprisingly, 10-year breakevens – that is, the gap between nominal and TIPS 10-year yields – also rose markedly. However, despite the appearance of a significantly more dovish Fed, breakevens, which had declined over the closing months of 2018 probably on the back of lower oil prices, did not climb back to the highs of 2.10% seen through much of 2018 and indeed remain below 2%. 

This muted response might suggest that the market questions whether the Fed’s reluctance to hike will be enough to let more inflation appear in the US economy. While the Fed appears to have raised the importance of inflation to justify further rate hikes, for now, the market seems to be acknowledging the Fed’s U-turn reduces the odds of a policy mistake, but there are still concerns about the Fed’s credibility, specifically in its ability to generate that inflation. 

From the other side of the Atlantic, euro investment-grade credit reacted to the dovish news with more enthusiasm than perhaps fundamentals warranted. While the Fed’s announcement could improve the economic fundamentals in the US, at this late stage of the cycle it is unlikely that credit would be an outperforming asset class. And in Europe it is much harder to see beyond the region’s lacklustre growth and heightened political uncertainties what might push spreads lower, let alone to outperform those of the US.

Currencies

At the turn of the year, there was a consensus that the dollar was going to weaken in 2019, as 2018’s superiority of US economic growth begins to lose status, signs of economic weakness appear, and the rest of the world takes up the slack in economic growth.

Interestingly, the Fed’s pivot has fuelled narratives for both bears and bulls. For the bears, forward-looking information from the likes of business and consumer confidence surveys are already pointing to economic weakness ahead. Coupled with the prospect of lower interest rates, the attraction of US assets becomes even less compelling.

For the more bullish dollar outlook, forecasters question the strength of economic growth in the rest of the world, and developed markets (DMs) in particular, pointing to weak soft and hard data appearing throughout Europe. 

For emerging markets, economic growth may be stabilising, and the easing of monetary policies across much of the DMs could add further support. In the absence of any meaningful dollar rally, carry could generate positive returns, although it helps if growth outlooks are at least stable, which they just may be now. 

The downside tail risk that is China’s economic stability, remains. China’s slowdown has not been smooth, and has been particularly difficult for investors to navigate although, thus far, policymakers have managed to come up with a variety of monetary and fiscal packages to keep growth up. Early this month could be particularly critical, given the confluence of the 1 March trade deal deadline and the release of combined January and February monthly activity data, delayed because of the Chinese new year.

Reading the runes of a death cross

Technical analysis back tests historical price movements of an asset, looking for patterns and formations to provide insight into where that asset might trade next. It has many proponents as well as a significant number of sceptics.

Successful investors are known for their pragmatism and humility. While some may disregard technical analysis as a specialist approach only for others, wiser managers acknowledge that it pays to keep eyes and ears open to a whole range of signals and noises and patterns.

Moving averages (MA) feature prominently in technical analysis, not least because they smooth out price data, allowing a clearer sense of the trend. Shortly after the Fed’s pivot, the 30-year US Treasury yield’s 50-day MA crossed below its 200-day MA, creating a formation called the death cross. 

This gloomily-named pattern is a technical signal for further asset declines, hence the sombre name, although obviously if it is signalling lower bond yield, however, a death cross is heralding higher bond prices. For the S&P 500 which entered a death cross in early December 2018, however, the index then carried on falling another 300 points over the next three weeks, before bouncing back.

Analysts at Citigroup looked at previous episodes when the US 10-year yield had entered either a death or the opposite, a golden cross, in an effort to quantify the usefulness of this technical indicator. Broadly, they found that 10-year US Treasuries rally just over 60% of the time in the three months after entering a death cross, an interesting but not, on its own, a necessarily compelling observation. 

Since 1990, there have been 25 death cross and 25 golden cross signals for 10-year yields, and the average change in yields under the former was a 35bps decline and a 5bps rise in the latter, over three-month holding periods, so maybe better to take more notice of a death cross? But Citigroup cautions that the findings may have more to do with the fact that yields have been in structural decline over the past two decades.

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