2018 Outlook: Adapting to the withdrawal of monetary stimulus

With major central banks now normalizing policies, there is a risk that investors will not absorb the extra fixed income supply until rates rise

Dec 6, 2017 | Stuart Edwards, Paul Read and Julien Eberhardt

Bond markets have been in a sweet spot in recent years. Economic growth has been positive, inflation has been relatively benign, volatility and default rates have been low, central bank policy has been accommodative and the demand for income has been high. One of the biggest challenges we as fixed interest investors now face is what happens when one of the central pillars of this supportive environment — the still huge amount of central bank stimulus — is reduced.

The macro view — Stuart Edwards

When thinking about the bond market implications of central bank tightening, it is worth taking a step back to understand why central banks now want to withdraw liquidity.

Since the global financial crisis, global economic growth has been relatively low but synchronised across developed markets. Recently, this has been helped by a pickup in global trade as a result of a resurgence in Asian trade flows and a recovery in North American imports. Meanwhile, labour markets have continued to tighten, but thus far the historically low unemployment rate has not fed through to wage growth, which remains muted. This does not, in my view, mean that the Phillips curve (the inverse relationship between unemployment and inflation) is dead — it has just flattened. For structural (as well as short-term) reasons, I believe labour markets need to tighten further before we see a pickup in wages.

I am starting to see some signs that this is happening, albeit slowly. Although it is not my central view, I think the risk is that inflation turns out to be stronger (not weaker) than expected. Against this backdrop, central banks are seeking to normalise monetary policy.

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