Global Viewpoints: Sovereign Debt – Central Bank Divergence Creates Investable Opportunities
In the first of a four-part series, Portfolio Manager Ryan Myerberg outlines why a benign backdrop of accelerating economic growth and target-level inflation leaves the U.S. Federal Reserve better placed than other major central banks to continue to gradually raise interest rates.
- With real GDP growth touching 4% and inflation near its 2% target, the U.S. Federal Reserve can continue to hike interest rates on a quarterly basis without risking a slowdown.
- Investable opportunities are created by the potential for continued flattening of the U.S. yield curve compared with possible steepening of the German yield.
- In part two of the series, Myerberg will outline how monetary policy differs at the European Central Bank and the Bank of Japan.
Myerberg: I think the Fed is in a very comfortable place. I think the economic backdrop is incredibly supportive of this slow and steady hiking cycle. For them, hiking once a quarter is a very comfortable pace. I think what’s been really interesting is that previously, in this post financial crisis cycle, the Fed was very hawkish in the sense that they thought that they could continue to hike over time and the market underpriced that and said there is no way you can do it. And the Fed had to come down and meet the market over time because they weren’t able to deliver consistent hikes. And we’re in a completely different environment now where the market is saying, “We don’t think you can hike once a quarter,” and the Fed is actually delivering on that. And so the market’s having to come to meet the Fed. If this pace of economic sort of expansion continues, and we’re talking potentially 4% quarterly growth, which is a massive number, 6 and change nominal GDP because inflation’s running north of 2%, the Fed should have no reason not to hike. Looking just at the fundamentals of the U.S. economy, there’s a reason why Powell has been pretty consistent in saying, “We can continue to go,” and the market is having to appreciate that this is a reality. That’s why you’re starting to see that repricing of expectations for the Fed.
For the Fed, monetary policy even now is still accommodative. They haven’t really tightened financial conditions that much. Credit spreads are low, equities are still pretty firm. So they can continue to deliver these hikes, keep policy relatively easy. Of all the central banks, the Fed is in the most comfortable place because the economic backdrop provides them the air cover to hike. And that’s different than, say, the ECB or the Bank of Japan, who are hiking possibly because they have to potentially. It’s not because they want to. So the ECB ending QE is a function of not having enough bonds to buy. There’s also a political component where the Northern Europeans are saying, “This is too accommodative. Growth is better. We need to turn off the taps.” So you have this idea of sort of a two-speed, central bank policy where the Fed is the best place, will continue to move in a more hawkish direction, and you have other central banks who really are tightening because they have to but need to be more accommodative because their economies really aren’t in a sustainable place in terms of growth inflation.
So over the next, call it 18 months, we should expect the Fed, all things equal, to just continue to hike once a quarter like clockwork, while the ECB stays pinned at -40 basis points. So I think that’s really important to think about that in the context of how do you invest in portfolios? Ultimately, we expect to see the U.S. yield curve flatten. The market needs to continue to price in those hikes in the front end. And until the Fed changes their sort of terminal dot expectations, the long end is relatively pinned and so you’ll see the curve continue to flatten. In Europe, for example, because the front end is pinned, but asset purchases are winding down, we expect to see the German Bund curve steepen where the 10-year will probably move higher with U.S. rates. Thirty-year should probably move a little bit higher. So there are investable opportunities across these different regions based on this forward-looking monetary policy expectation.
The missing piece in all this in terms of what the yield curve looks like in the U.S. is inflation. If you don’t see this material move higher in inflation, then are you going to really see a mass amount of term premium come back into the curve? We’re not necessarily convinced you’re going to see inflation come back 4%, 5%, we sort of expect to see inflation come back slow and steady. Wages will probably pick up. And that I think that sort of allows the Fed to continue on this path. If you did see that inflation come back in an aggressive sort of way and the Fed was sort of behind the curve in terms of their ability to dampen that inflation, then I would expect to see U.S. yield move materially higher, term premium to return.
Foreign securities, including sovereign debt, are subject to additional risks including currency fluctuations, political and economic uncertainty, increased volatility, lower liquidity and differing financial and information reporting standards, all of which are magnified in emerging markets.
Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.
Quantitative Easing (QE) is a government monetary policy occasionally used to increase the money supply by buying government securities or other securities from the market
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