In our last strategic outlook, we warned that a worsening trade conflict could lead to a revision of our forecasts. This has now occurred indirectly. Although the conflict has not escalated recently, central banks referred to it as one of the reasons for their renewed "dovishness." We had predicted that the U.S. Federal Reserve (Fed) would leave interest rates on hold for that period. We have now penciled in a reduction of 50 basis points, which would equal two rate cuts of 25 basis points each. For the European Central Bank (ECB) we expect looser policies too in coming months. Most probably, the ECB will try to do this via one cut of 10 basis points in the deposit rate and the implementation of a tiering system for commercial banks parking money with the ECB.
Uncertainties around these forecasts are unusually large. They mostly reflect changing rhetoric from the central banks themselves, rather than the occasional pockets of weaknesses in incoming economic data. Dovish central-bank rhetoric, in turn, appears to be mainly driven by falling bond yields, and in particular declines in inflation expectations. Rightly or wrongly, many market participants appear to think that the tariff wars could unleash deflationary forces again around the world. And the Fed seems to be edging towards the conclusion that this will justify cutting rates pre-emptively.
Against this backdrop, we are reducing our U.S. Treasury forecasts until June 2020 by 30 basis points along the yield curve, compared to our previous targets, while leaving U.S. corporate-bond spreads unchanged. The picture for European sovereign bonds is similar. Whereas for European corporate bonds, we expect spreads to tighten, on the back of hopes that the ECB might eventually revive its bond-purchase programs. For the same reason, we also expect spreads for riskier Eurozone sovereign bonds to tighten.
Most of our other 12-month targets remain unchanged, including in particular those for all major equity indices. This reflects our concern that even if no new tariffs are implemented, corporate margins are likely to suffer from the ones already implemented. And, in the face of lingering trade wars, it is far from clear that the modest rate cuts, we now envision, will suffice to give equity markets another boost. It is equally possible that we see a market correction, before the Fed cuts. At least, that would provide a better justification for such a cut than what we have seen so far.
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