“We are committed, and are not resigned to having a low rate of inflation forever or even for now.”
-Mario Draghi, ECB President,
June 18, 2019
Investment Managers Securities Analysts
Bermuda & Cayman
The world’s major central banks have shifted away from monetary policy tightening amid slowing global economic growth, low inflation, and trade tensions. In the US we expect the Fed to cut the benchmark rate in Second Half 2019. All major central banks are sensitive to economic growth and will fine-tune interest rates and other stimulus programmes in a measured way, thus preventing their economies from going into recession.
In less than six months investors have gone from pricing in three Fed interest rate hikes to three cuts. In June, the Fed indicated a readiness to cut interest rates emphasizing low inflation. To summarize:
1. The Federal Open Market Committee (FOMC) wants to keep the expansion alive as long as inflation is not alarmingly high.
2. Inflation has fallen. Even if this is transitory, inflation is persistently low. Persistent, transitory low inflation can become persistent, systematic low inflation if inflation expectations fall.
3. Inflation expectations have fallen.
4. The implication is the FOMC could cut rates as soon as the next meeting in July.
The market was pricing in interest rate cuts before the Fed’s June statement as evidenced by the inverted front end of the yield curve (i.e. three-to-five-year yields were lower than the overnight rate). For this reason, we do not expect a sharp decline in yields on the Fed’s more dovish tone. At this point in the economic cycle, we prefer corporate bonds with strong investment-grade credit ratings over lower rated, relatively better yielding ones as corporate spreads over Treasuries are likely to widen significantly on lower rated bonds with a resulting decline in price amid recession fears.
Monetary policy easing in Canada is unlikely absent clear evidence of domestic economic deterioration. Economic data has mostly come
in better than expected in Second Quarter 2019 and the central bank will remain decidedly data dependent. The central bank’s May 2019 statement signaled a steady as she goes approach while being mindful of external downside risks to growth.
In the eurozone, the central bank is prepared for action to boost inflation unless the outlook for growth improves and ECB President Mario Draghi is expected to deliver a rate cut before the end of his tenure on October 31, 2019. Draghi has also hinted that the Governing Council may be willing to tolerate inflation running above the ECB’s goal to compensate for the recent, protracted period of below target price gains. To achieve this further interest rate cuts or a restart of the asset purchase programme may be needed.
We expect the Bank of England (BOE) to stay on hold through 2019, waiting for more clarity on Brexit and as global trade tensions pose a downside risk to the economy.
The tight labour market has pushed wage growth to a cycle high. Combined with weak productivity, this has driven an increase in labour costs. However, this has not yet translated into rising inflation, which stands at an annual rate of 1.9 percent, as weak demand has led companies to restrain from passing on costs. As such, the BOE can bide its time for clarity on Brexit before making any changes to monetary policy.
The Bank of Japan can deliver more monetary stimulus if necessary. Governor Haruhiko Kuroda has emphasized that the central bank does not need to act now, citing the health of the economy and that policy makers need to take care with side effects from monetary stimulus on the financial system.