The US Federal Open Market Committee (FOMC) statement and subsequent press conference led by Ben Bernanke has added considerable near-term volatility into the markets. The FOMC is hardening in its view of an early tapering of quantitative easing (QE).
The key impression given from the statement and subsequent press conference is that the Federal Reserve (Fed) is determined to taper quantitative easing before the end of the year. Forecasts are likely to continue to centre on a move by the Fed in September. Fed Chairman Ben Bernanke suggested that it might end its QE entirely in mid-2014 if the economy is on a path of sustainable growth.
The Fed still expects the inflation to be at or just below its 2% target
This was the key surprise. Bernanke talked about a number of one offs that are keeping inflation low at the moment and that they expected to reverse. However if you look around the world at the moment there are many signs of falling inflation.
The Fed increased its growth forecast
Fed increased its GDP forecasts for 2013 to 3-3.5% from 2.9% to 3.4%
We suspect that the FOMC has made a policy mistake. We do not believe that growth is as robust as the way the Fed has characterised it and we don’t believe that inflation will pick up to the degree that the Fed expects. The tough call is knowing when the Fed might shift its view again.
Our initial reaction
Bonds – value appearing but stick to quality
US 10 year yields have spiked 17bps to 2.35% the highest since early 2012. 2.35% compares with an average of 1.77% over the past 12 months. In the absence of markedly weaker data the 10 year government bonds will probably stay in a new trading range of 2.10-2.50%. If the Fed is right and inflation and growth hit their targets then the 10 year bond might eventually settle at around a yield of 3%. In the past two weeks there has been $17.7 billion of redemptions from bond funds.
Emerging market (EM) bonds are trading lower following the pattern of the previous sell off. We believe he volatility of the EM bond markets and the over-ownership by foreign investors will keep the downward pressure on prices. Previous weak markets such as Philippines and Indonesia are likely to remain under pressure. We continue to look for selective opportunities in higher quality credits with relatively short duration.
Equities – developed preferred over emerging
We expect developed market to outperform emerging markets. In the near term investors are going to worry that higher US rates will encourage further flows of capital out of the emerging markets. Also those investors who believe the Fed is making a policy mistake will worry that emerging market growth will be hurt by any slow down in the US. Our preference in the developed markets is for Japanese equities where we believe that after the Upper House elections the policymakers will provide further detail on new reform policies
Dollar positive
Dollar rallied around 1% on expectations of flows into the higher yielding greenback. The outlook is heavily dependent on whether Chairman Bernanke convinces investors that the US growth outlook is strong enough to warrant some scaling back of policy support. If this is correct, it should support our view that the dollar will see gains versus other major currencies, in particular yen, the Swiss franc, the euro and sterling. In addition, an environment where US growth is picking up but the global policy stance remains – from an historical perspective – very accommodative should support a recovery in emerging market and commodity-based currencies after their sharp sell-off in recent weeks.
However, this outlook is very dependent on the Fed being right. If the Fed withdraws policy support too early and the US economy does not recover as it expects, then markets are likely to respond very negatively. The immediate reaction to Chairman Bernanke’s remarks – a sharp sell-off in global equities and big falls in emerging market and commodity-based currencies – suggest that markets for now are not convinced. If incoming US economic data does improve, the dollar should consolidate gains versus other major currencies, and current weakness in emerging markets and commodity-based currencies could represent a great buying opportunity. If however, the data disappoint and markets remain worried that the Fed will adjust policy anyway, then we can expect continued risk aversion and further weakness in these more volatile currencies.
For now, we recommend a cautious approach. Our broadly pro-dollar view has reflected our assessment that the US economy is likely to see further recovery over the medium-term, but we are not as confident as the Fed appears to be. More importantly, we see a big risk that the market will not be as confident as the Fed for some time. Until market expectations for growth are aligned with those of the Fed we may be in for a rough ride.
Gold – under pressure in the wake of dollar strength
Gold is back to the level seen in the wake of the market collapse in April. The downside risk is to the $1300 level, a level last seen in January 2011. If that level were not to hold then a move back to $1150 is possible.
