Weekly Bond Bulletin

22 June 2017

Liquidity rolls on

The Federal Reserve (Fed) has just announced its plan for reducing the size of its balance sheet, but liquidity remains abundant across the G4 as a whole. Will supportive technicals continue to underpin performance of risk assets?

Fundamentals

While growth is positive, inflation remains elusive for many developed markets. In the US, May’s core inflation reading declined to 1.7% year-on-year, down from 2.2% in February and the slowest rate since May 2015. Europe presents a similar picture of inflation resistance, with both core inflation and wage growth stubbornly low. Although Japan’s core consumer inflation measure rose for a fourth consecutive month in April, it remains far below the Bank of Japan’s (BoJ’s) 2% target. Despite this weak inflationary backdrop, G4 central banks are, at least on the face of it, becoming marginally less accommodative, given positive economic activity and improving labour markets. The Fed continues to normalise its policy rate, hiking by a further quarter point in June, and is on course to do the same with its USD 4.5 trillion balance sheet in the coming months.

Quantitative valuations

The US yield curve responded to the conflicting picture painted by the hawkish Fed tone vs. weaker inflation prints by flattening towards levels last seen in late 2007. While shorter maturities continue to price in the prospect of nearer-term policy normalisation, the longer end of the curve has outperformed on renewed expectations of more persistent disinflationary trends. This represents yet further pricing out of the Trump reflationary trade, or at least an acknowledgment by the market that, while higher growth might be achieved, inflation is not guaranteed to follow. Though credit and higher-risk segments of the fixed income market appear to be fully valued, we see no clear catalyst that would cause them to widen materially.

Technicals

The Fed’s announcement of its balance sheet reduction strategy has brought a degree of clarity to the evolution of liquidity conditions in the coming quarters. Initially, the Fed looks set to allow USD 6 billion of Treasuries and USD 4 billion of agency and mortgage debt to mature each month without reinvestment, with this process likely starting in Q4 2017. The pace will be increased incrementally each quarter over a period of 12 months, until a total of USD 50 billion of Fed assets run off the balance sheet monthly. While we also expect both the European Central Bank and the BoJ to taper their asset purchases, the overall size of G4 central bank balance sheets should continue to expand on aggregate until Q4 2018, before starting to contract. Risks to this view are skewed to the dovish side: if inflation remains benign, the ECB may take a slower approach and the BoJ might taper by less. Thus, global monetary policy looks set to remain loose, and liquidity conditions ample, for several quarters to come. Ultimately, this expanse of cash needs to find a home, and this should ensure that the supportive demand technicals for fixed income assets remain in place.

G4 central bank balance sheets look set to continue expanding until Q4 2018

What does this mean for fixed income investors?

While recent headlines have focused on the Fed’s plans for withdrawing liquidity from the system, it’s important to note that central bank balance sheets look set to expand further into Q4 2018, before starting to reverse course. For investors, this means a continuation of the supportive demand technicals for global fixed income, and particularly for spread products. Furthermore, while the Fed remains committed to a path of rate normalisation, the persistent lack of inflation, combined with diminishing inflation expectations, should provide incentive for policy to err towards gradualism, leaving duration rangebound. The overall picture remains supportive for fixed income, though investors need to be wary of pockets of volatility emerging.

About the Bond Bulletin

Each week J.P. Morgan Asset Management’s Global Fixed Income, Currency and Commodities group reviews key issues for bond investors through the lens of its common Fundamental, Quantitative Valuation and Technical (FQT) research framework.

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22 June 2017
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