Fixed Income 1Q19: Headwinds galore

We recommend holding a highly-diversified portfolio of bonds
Chief Investment Office25 Jan 2019
Photo credit: AFP Photo

Global monetary conditions are likely to get even tighter in 2019, marking a third year of higher DM rates. The US, Eurozone, and Japan should see interest rates grinding higher as their respective central banks continue to (or signal their commitment to) withdraw monetary stimuli. However, the pace of tightening will differ between the Federal Reserve, the ECB, and the BOJ. We think the bulk of the tightening will still be delivered by the Fed in 2019 (another four hikes, taking the Fed Funds rate ceiling to 3.50%), while the BOJ will continue to taper. Meanwhile, the ECB will be on pause, prepping for a hike only in 2020.

With US GDP growth running above 3% for two consecutive quarters, y/y CPI still hovering above 2%, and the unemployment rate hitting new lows, further rate hikes are needed – even with US President Donald Trump’s criticism of the Fed. Tightness in the labour market is translating into higher wages. Notably, y/y average hourly earnings have been hovering above 2.5% since December 2017, and the pace of wage gains appears to be accelerating. We suspect that the market (currently pricing in two hikes for 2019) is underestimating core inflation risks and Fed hike risks. On another note, the Fed’s balance sheet is now shrinking at the maximum planned pace of USD50b per month. Since the peak in early 2015, its balance sheet has shrunk by about USD350b, with the bulk of this occurring in 2018. Excess reserves have also fallen accordingly, tightening USD liquidity in the process.

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