Central bank dovishness is, more often than not, interpreted as a sign that the region’s economy is primarily sub-par (below expectations) in terms of growth prospects, lending itself to an underlying issue faced by central banks worldwide, and that is inflation. Every central bank’s monetary policy is driven by a number of key forces, the most common one being that of inflation, or rather, the long-term inflationary targets of economies. Inflation, in simple terms known as the rate of price increases in an economy, is a key metric in measuring the health of an economy vis a vis all the prevalent market forces.
Those who have been closely monitoring the markets in recent months or, say, over the past couple of years, would note a significant turnaround in stances, tones as well as forward looking statements for the major central banks across both sides of the Atlantic.
If you recall, September was the month when the ECB formally announced the termination of its Asset Purchase Programme (an accommodative monetary stance by the ECB which includes the purchasing of bonds - sovereign and corporate - on the secondary market). This was a clear sign interpreted by the market that the ECB’s stance was slowly shifting from a 5-year long dovish stance to the beginning of some hawkish inclinations in its terminology.
December followed, and the markets were faced by an unfamiliar rate hike in the US by the Federal Reserve. Different scholars argue whether that was the right decision at the time, given the market conditions, but the subsequent FOMC meetings by the Federal Reserve had a significant shift in tone.
In January, an announcement was made that incoming economic data dictated that the market should expect fewer rate hikes than were previously being priced in. A couple of weeks ago, this change in stance to more dovishness was reinforced when the US Federal Reserve Open Market Committee stated that no rates are to be expected this year. A similar marked shift in stance by the ECB was also noteworthy, as the prevalent inflationary data prints continued to indicate that the ECB was well below its long-term (5-year) inflationary target of 2.0% and also recently announced a fresh wave of cheap bank loans.
At first glance, this shift in policy might be interpreted as a negative for credit markets. However, particularly in Europe where leverage levels are much lower than they are in the US, credit remains strong and spreads still have significant room to tighten. With the recent moves in the yields on benchmark 10-year Bund and Treasury changing significantly, we believe that credit has the ability to grind tighter, especially in a lower-for-longer ultra low yield environment.
Money managers seem to be laden with cash, the global hunt for yield is still prevalent, and with inflation expectations in Europe well below target expectation, the long-end of the curve could well be on the cusp of more bull-flattening.
Talking about yield curves, the US yield curve has now officially inverted, and this means that yields on shorter-dated paper are higher than those on longer-dated Treasury Bonds for the first time since 2007. Should this inverted curve persist over a longer period of time, and if history is a good indicator of what is to come, then a recession in the US is possibly on the cards, but imminent anyhow.
Till then, we expect credit markets, particularly the spread direction, to follow the patch of their benchmark yields, and therefore tighten from this point forth, albeit in a gradual manner.
Disclaimer:
This article was issued by Mark Vella, investment manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt . The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.