A busy week for central banks

A big week for macroeconomic announcements has already seen a drop in UK inflation and ongoing Brexit transition talks, while a monetary policy decision from central banks both sides of the Atlantic is coming on Wednesday and Thursday, but what does it mean for markets?

A busy week for central banks

The upshot of Monday’s agreement was that the transitional period will run from 29 March 2019 – the date the UK is set to officially leave the EU – until 31 December 2020. During this time, the UK will be able to negotiate its own trade deals and still be involved in existing EU trade deals with other countries.

This was welcomed by industry players as a positive for the UK economy and, along with a lower inflation figure, a further boon to the Bank of England ahead of its Monetary Policy Committee (MPC) meeting on Thursday.

So how will this affect the BoE’s plan for future rate rises and what does the US Federal Reserve have up its sleeve for Wednesday?

Pressure’s off the BoE

According to Axa Investment Managers senior economist David Page, there is unlikely to be any change to rates from Threadneedle Street on Thursday, but the transition agreement has removed downside risk over Brexit making it more likely the bank will hike at its May meeting rather than in August when the firm is currently expecting it to.

The strengthening of sterling following the transition announcement has relieved some of the pressure on the BoE to hike in the near term. So has the ONS’s latest inflation figure, published on Tuesday, that revealed the Consumer Prices Index dropped to 2.7% in February, down from 3% the month before.

This is still a way off the bank’s 2% target but suggests a gradual downward trend in inflation, which according to Kevin Doran, chief investment officer at AJ Bell, creates breathing space for the MPC when it comes to increasing interest rates.

Doran says: “However, solid economic data and the risks around sterling depreciating further, especially as we move closer to the realities of impending Brexit, are likely to see Mark Carney and fellow members remain poised to raise rates again in the near future.”

Dan Smith, investment analyst at Thomas Miller Investment, does not foresee a rate increase at this week’s meeting, but does believe the BoE is saving itself for a hike in May.

“We expect this meeting could be the platform for the BoE to signal to markets that another interest rate rise is likely in the months ahead,” he says. “Key to this outcome will be the trend in inflation, employment and retail sales numbers released earlier in the week.”

All eyes on Powell’s dot plot

Wednesday’s US Federal Reserve meeting meanwhile, is likely to be a slightly busier affair than the BoE’s.

It is the first Fed meeting under new chairman Jerome Powell who is unlikely to want to rock the monetary policy boat, as Karen Ward, chief market strategist at JP Morgan Asset Management believes.

Ward says: “The new chairman of the Federal Reserve has a difficult balancing act ahead. First and foremost, he must cement his credibility. He must demonstrate that he and his committee will act independently to meet the Fed’s employment and inflation mandate.

“He will need to acknowledge therefore that the new set of forecasts are conditioned on a much larger fiscal stimulus, one which could amount to 1% of GDP both this year and next. That is not a small addition to growth and given unemployment is low it could have implications for inflation.

“At the same time, he will presumably not want to upset the administration with a new plan for monetary tightening to offset the fiscal expansion.”

Indeed, the consensus that the Fed will increase rates by 0.25% on Wednesday is largely priced in. Attention will therefore be on the committee’s projection for future hikes – its ‘dot plot’.

The Fed’s dot plot predicts three rate rises this year, but word on the street is that this could be bumped to four depending on, according to Smith, whether mounting political uncertainty converts into economic concern.

Smith says: “The most interesting and market moving aspect of the meeting will be the committee’s projections for interest rate rises this year, with growing expectations this will be increased from three to four.

“If expectations are proved correct, this may be the catalyst that reasserts the trend of government bond yields moving higher.”

But for Damian Testi, investment manager at Walker Crips, hikes will be “steady and gradual” on a quarterly basis throughout the year, occurring for sure in March, June and September, but increasingly unlikely in December.

He explains: “The key factors that drove the solid start to US equity indices at the beginning of the year arose from US tax reform, corporate tax repatriation and a weakening US dollar. Now that the first quarter of the year is nearing an end, market volatility has reared its head from its slumber in 2017.

“Diligent attention needs to be paid to US politics. Growing political uncertainty is showing signs of morphing into economic uncertainty, which is why a December rate hike sits in the balance. The headwind of political disarray – if it continues to escalate – could lead to a very different dot plot for interest rates in the US in 2019.”

Wary on corporate credit and duration

Andrew Harman, senior portfolio manager of multi-asset at First State Investments, will be looking out for the dot plot and Powell’s language around longer-term growth to inform his portfolio positioning.

“We expect the gradual unwind of quantitative easing and removal of liquidity from the system to put upward pressure on corporate credit spreads; especially short maturity,” he adds.

“As a consequence, we are avoiding high yield and investment grade corporate credit given already rich valuations.”

Invesco Perpetual co-head of fixed income Paul Causer notes the fact the Fed has raised rates four times since December 2016, has begun to reduce its balance sheet and is expected to hike three to four times this year, points to a strong economy.

He adds: “Such a strong backdrop would suggest that US duration risk is unlikely to be appealing until yields are back towards their pre-financial crisis range of 4-4.5%.

“However, while we believe that US government bonds are in a managed bear market, there are reasons why they could become attractive before they reach their pre-crisis levels of yield.”

 

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