Bond markets are unconvinced how effective central bank tools are


A flickering light never goes out for equity markets, especially one kindled by the hope of central bank easing.

No matter the current hard ball stakes between the US and China over trade and technology, the MSCI All-World equity index loiters within touching distance of this year’s peak. The narrative of rebounding global growth and expectations of President Trump striking a “beautiful” trade deal subsequently withered during May, but the profound decline in government bond yields has provided a security blanket for broad equity performance.

One can look at equities and bond yields and conclude that one of these markets is very wrong. Or perhaps view stocks as being typically optimistic, while government bonds are overly pessimistic about the course of Sino-US trade negotiations and the future trajectory of the global economy. Investors have much to chew on after Broadcom’s warning this week about slumping demand for semiconductors, which highlight the damage being wrought by the trade war.

At the very least, investors enter the second half of the year with plenty of stimulus, via slumbering long-term bond yields, supporting the financial system and providing reasonable cause for some equity market optimism.

That backdrop also shapes the likely course of next week’s US Federal Reserve meeting. Given the lack of any substantial pushback by Fed officials in recent weeks about Treasury yields, led by the policy sensitive two-year note falling well below the central bank’s overnight rate, an easing bias looks likely. That stands to keep the light glowing for equity and high-yield credit.

Outlining even a hazy easing bias before the late-July meeting will buy the Fed some time before affirming the bond market’s call and the size of their balance sheet. Another employment report arrives in early July, which should either bear out the poor reading for May or paint last week’s disappointing result as an aberration.

A dovish signal from the Fed will help limit a negative market fallout from a tempestuous G20 meeting in which little progress is made between the US and China. Under that scenario, equities and credit will anticipate a rate cut in July, thereby flipping bad news from the G20 into the usual short-term bounce for risk appetite. Under those circumstances, expect a market clamour for a 50 basis point cut that provides a hefty dose of insurance.

Beyond the current duelling scenarios of a more patient Fed, or one that cuts slowly or perhaps with some dash, a far more troubling aspect of declining bond yields merits consideration.

Usually, the risk of central bank easing pushes up long-term inflation expectations. Instead, falling inflation expectations typify both the US and eurozone, highlighting how major central banks are being challenged by the bond market over the effectiveness of their tools.

The pace of declines in forward measures of US and eurozone inflation expectations, with the latter plumbing to a record low this week, has accelerated since late April, accompanied by falling prices for crude oil and key industrial metals. Anyone thinking bond markets are wildly wrong about the prospect of low yields for an extended time should ask what’s going to fire up inflation expectations.

Aggressive central bank policies over the past decade delivered a modest recovery, with a backdrop of low bond yields elevating asset prices and global property markets. Notably the Fed’s efforts at normalising policy — one accompanied by a strengthening US dollar — quickly clipped the global economy, a trend hardly helped by the use of tariffs as a weapon by the US against China.

This underscores the vulnerability of a global financial system marked by high levels of debt to even a modest tightening in funding costs and/or a stronger dollar. What would break this dependence would be stronger growth and accelerating inflation that helped to alleviate debt burdens, but it’s a combination that remains elusive. Worryingly, the slowing pace of the US economy, after a fiscal shot in the arm last year, underlines how growth has not sustained at higher levels.

Little wonder, Mr Trump wants lower rates from the Fed and a weaker dollar. So does Wall Street and global equity investors, hopeful of an insurance easing from the Fed, which, like 1995 and 1998, kept the economic show running, thanks to robust productivity.

Today, global corporate profit margins are under pressure and plenty rides on whether low bond yields deliver a second-half boost to growth and earnings.

Risk assets such as equities and credit can endure an economic soft patch and one that is arrested by pre-emptive policy easing. A harder landing by its nature takes time to unfold and does dim the lights.

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