As expected, Federal Reserve Chair Janet Yellen’s speech in New York dominated market narratives yesterday. Her dovish message reverberated as the odds of a rate hike before mid-year implied by futures markets tumbled well below 50 percent. Yellen was not the only central banker making waves. Today Lee Ju Yeol, the governor of the Bank of Korea, guided expectations of growth prospects lower and paved the way for further rate cuts for South Korea’s financial system. With the global rate environment now expected to remain accommodative for the foreseeable future, equity markets rebounded globally in the waning days of the first quarter. A G-20 conference in Paris tomorrow will likely provide more insight for investors as central bankers attempt to keep a so-far “cold” currency war from heating up.
Rousseff’s coalition frays. Today one of the largest individual political parties in the Brazilian legislature, the Brazilian Democratic Movement Party (PMDB), announced it will leave the ruling coalition headed by President Dilma Rousseff’s Workers’ Party. The announcement was followed by resignations by PMDB officials that back an impeachment of the president over a widening scandal related to the state-owned oil company Petrobras.
Factory output declines in Japan. In the latest signal that growth prospects for Japan’s economy remain in doubt, February industrial-production data released today by the Ministry of Economy registered a 6.2 percent contraction versus January, a 1.5 percent decline on a year-over-year basis. The slump comes as declining export demand weighs on the manufacturing sector despite massive easing efforts by the Bank of Japan.
Malaysia’s wealth fund moves to cut debt. 1Malaysia Development, the Malaysian sovereign wealth fund, today announced that it will sell assets to entirely eliminate short-term and bank-loan debt totaling more than $1.5 billion. The state-controlled firm has been at the heart of a political controversy within Malaysia as accusations of improper management by Prime Minister Najib Razak, who heads the firm’s board, emerged after investigations into the fund’s activities in multiple nations.
Portfolio Perspective: A More Cautious Fed Should be Good Market News — Robert Tipp, Prudential Fixed Income
The chair’s speech yesterday continued the path blazed at the March meeting: deemphasizing the signs of strength and higher inflation in the U.S. economy, and instead, biasing her comments towards exercising caution given downside risks and pockets of weakness — particularly on the international front.
While economic results in the U.S. have been moderate, and arguably with a preponderance of signs that inflation is in fact moving towards rather than away from the Fed’s chosen target, the Fed has scaled back its expected path of rate hikes. Since this is ostensibly at odds with the progression of the U.S. economy, it begs the question: Why is the Fed doing this, and furthermore more, why should it be good for the markets?
Presumably, the drivers are:
1. The perception of vulnerability in financial markets, and
2. The much softer growth configuration beyond U.S. shores.
While the Fed learned the downside of a hawkish trajectory in the runup to their September 2015 meeting — namely, that if it looks like they’re setting up for a string of hikes, financial conditions will tighten significantly — they are now perhaps extrapolating that if they tone down their expected rate hike path, that will help to ease financial conditions, i.e., private sector borrowing rates will fall and equities will rise, and thereby boost the U.S. and global-growth picture.
Of course, if the risk of the U.S. economy overheating as a result of a slow-go Fed were rising, we would expect to see long-term U.S. rates rise, and the effort backfire. But in today’s globalized economy, given widespread underemployment and capacity under-utilization, the markets — probably quite aptly — appear to be waving off the risk of an upward wage-price spiral occurring. Which brings us to why this is good for the markets.
To the extent that fear of the Fed has kept investors out of the bond market, the Fed’s trend of downgrading its rate-hike trajectory is likely to make investors more comfortable with bond market prospects, and thereby reignite the search for yield. In turn, this should contribute to a low and range bound yield curve, and cause spreads on the non-government sectors, such as structured products, emerging markets debt and investment grade and high yield corporate bonds, to narrow.
All said, this should allow fixed-income product to continue to significantly outperform cash over the intermediate to long term. Furthermore, the uncertainty created by this new and dynamic policy backdrop and the low-rate environment should continue to offer good opportunities to add value through active management.
Robert Tipp is chief investment strategist and head of global bonds and foreign exchange for Prudential Fixed Income in Newark, New Jersey.
