Jun 12, 2019 Central banks

Neither cuts nor hikes. So far.

  • Interest-rate hikes appear to be off the table for now and the market already expects rate cuts in the U.S. this year. We do not.
  • We expect most government-bond yields to move sideways. This makes U.S. sovereigns interesting again.
  • Elsewhere, our focus is on corporate and emerging-market bonds with attractive yields.
to read
by Jörn Wasmund, Head of Fixed Income/Cash

Having just taken interest-rate hikes off the table, the market is putting interest-rate cuts on. Too soon, we think.

Interest-rate 'normalization.' It was an encouraging term for European savers and retail banks: signaling happier days when interest rates would return to more normal levels, ones that would pay savers more on their deposits and banks more on their loans. What happened to the normalization story? It has fallen victim to our still exceptional times.

The turnaround is stark. Further rate increases were expected in the summer of 2016, half a year after the Federal Reserve (Fed) began its interest-rate hiking cycle. Yields on both sides of the Atlantic picked up fast: 10-year U.S. Treasuries rose from 1.35% to 3.23% (December 2018) and Bund yields rose from -0.2% to 0.77% (August 2018). Briefly, U.S. yields even broke out of their almost 35-year downward trend.

But it took only a little while for yields to get dizzy on their upward climb – and they went back down again. The reasons for the renewed downturn were quickly identified: weaker economic data and sentiment indicators, followed by a turnaround in the line taken by major central banks whose hawks fell from their perches while the doves started to fly.

The renewed concern about economic growth is well documented in two data points: banks and brokers have reduced their global consensus growth forecast for 2019 from 3.7% in July 2018 to 3.3% now. Over roughly the same period, the oil price has lost about a third of its value. Since inflation expectations in most countries have also fallen again during this period, the decline in government yields is not entirely surprising.

Meanwhile the foreign- and trade-policy ideas and tweets of the U.S. President have again proven surprising and disruptive, altering the global economic picture. In May, negotiations with China were virtually ended by his announcement of new tariffs. The threatened punitive tariffs on car imports, which are presumably compromising U.S. security, were not revoked, but only postponed. Mexico, to everyone's surprise, was threatened with new punitive tariffs unless they supported the U.S. in stopping illegal migration via the U.S.-Mexican border. India's special trade status was revoked because of "unfair practices." Plans to impose punitive tariffs on Australian aluminum imports were prevented by the U.S. Defense Department. We believe that the accumulation and escalation of trade disputes will only be noticeable in global economic figures in 2020. The consequences, however, are becoming evident in capital markets, financing conditions and sentiment indicators. 

As annoying as these developments may be, it should not be forgotten that they are taking place when the global economy is quite robust. Labor markets are still strong on both sides of the Atlantic. We expect growth of 3.4% in 2019 and continue to expect no significant spurt in inflation. And we note that the persistent low-interest-rate trend is not only due to short-term developments. The chart shows that the decline in interest rates in developed countries is a longer-term phenomenon. Whether it's demographics, debt levels, globalization or digitization that is driving this will be examined in more detail in a separate note.

Trend in 10-year government bond yields. Zero as the lower bound more or less holds for now.

Source: Refinitiv as of 6/3/19

Our 12-month forecasts for bonds and currencies were also dominated by the renewed decline in yields. The epicenter was once again the United States, where we made the biggest changes for sovereign bonds. We have lowered the yield forecast for 10-year Treasuries from 3.0% to 2.3% and for 2-year Treasuries from 2.75% to 2.0%. Thus, on May 23, we predicted that yields would fall again – for the first time in a long time. However, interest-rate developments have now overtaken us and our forecasts are above current yields. Again, our impression is that Trump's actions may be part of this. The changed tone at the Fed, where Governor Jerome Powell has shifted from calling the key interest rate a long way from neutral in October last year towards a Trump-like point of view is certainly remarkable.[1]

Interest-rate hikes in the U.S. appear to be off the table for now, and the market expects two to three interest-rate cuts before the end of the year. We doubt that. The labor market remains solid. And there is a danger that the trade wars will push up inflation, and not just temporarily. We therefore stick to our forecast of an unchanged federal funds rate. However, we do not expect any further increases in this interest-rate cycle. We believe U.S. government bonds are likely to trend sideways over the next 12 months after the sharp yield declines around the turn of the month. The same applies to German government bonds, although we expect them to trend slightly higher until mid-2020.

We see clearer movement for UK Gilts. In twelve months there should be more clarity in the Brexit saga and a new prime minister, or even a new government. We do not expect an economic slump but inflation may move above target because of the weak pound. We therefore expect the Bank of England to raise interest rates and 10-year Gilt yields to rise to 1.5%. Among Europe's peripheral states, we continue to favor Spain over Italy.  

While others stayed flat, U.S. and UK policy rates were increased recently. For the U.S. we might be at the peak.

Source: Refinitiv as of 6/4/19

In our view, bonds with higher yields are more attractive in the persistently low interest-rate environment; for example, corporate bonds from Europe and the U.S. We prefer high-yield bonds in Europe and investment-grade bonds in the U.S. In emerging markets, we continue to prefer hard-currency bonds. For corporate bonds from this region, we particularly like the high-yield segment.

As far as currencies are concerned, we are sticking to our forecast of 1.15 dollars per euro for the euro-dollar pair. Though we believe the euro could weaken to $1.10 or below in the near term, we think that the dollar will slowly weaken at the end of our forecast horizon. To hedge against major market distortions, we continue to rely on the yen. We expect the Chinese currency to weaken only slightly. Although a decline in China's net exports would encourage a weakening of the currency, we do not believe that Beijing will favor a marked devaluation of its currency in the medium term.

This information is subject to change at any time, based upon economic, market and other considerations and should not be construed as a recommendation. Past performance is not indicative of future returns. Forecasts are based on assumptions, estimates, opinions and hypothetical models that may prove to be incorrect.

DWS Investment GmbH as of 6/6/19
CRC 068361 (6/2019)

1 . On May 14, the U.S. President tweeted that the Fed should follow the Chinese monetary-policy path and cut rates. At the time, many people thought this more of a reason for the Fed to leave interest rates unchanged in order to show its independence. But less than three weeks later, James Bullard became the first Fed member to sympathise with the President’s line. The voting member of the Federal Open Market Committee (FOMC) said at the beginning of June: "The financial markets could be affected by the trade conflict to such an extent that a downward adjustment of monetary policy could soon be justified." Bullard is, however, one of the chief doves among U.S. central bankers and we do not want to over-interpret his view therefore.

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