Have central banks restored their authority?

Despite a dovish tone in its monetary policy announcement on Wednesday, the US Federal Reserve's tightening bias still puts it on a diverging path from other major central banks. However, recent actions from the European Central Bank and the Fed helped allay the worst fears that they have become ineffective or insensitive to market concerns. These actions have also supported a rally in credit, an area where we currently hold our overweight positions and where, on a risk-adjusted basis, we have seen the strongest performance of the major asset classes recently.

The Fed left its target range for interest rates unchanged at 0.25-0.5 percent. It also scaled back its projection for future rate increases. The median forecast of Fed officials, as shown in the dot-plot, is now pointing to two rate rises for the rest of this year versus expectations for four hikes at the time of the December meeting. 

The Fed cited risks from global economic and financial developments as justification for keeping rates on hold. At the same time, it said the domestic economy was “expanding at a moderate pace,” which we believe implies a tightening bias. 

As of the time of writing, investors are still more dovish than the Fed, with interest rate markets pricing only 10 basis points of hikes this year against 50 basis points from the Fed’s dot-plot. For 2017, the gap is even wider. The market is expecting around 90-95 basis points of hikes versus around 150 implied by the dot-plot. We believe this is likely to generate continued volatility as markets adjust closer to Fed expectations. 

We remain overweight US and European high yield bonds

Other recent major central bank decisions have diverged from the Fed. The European Central Bank (ECB) cut deposit rates deeper into negative territory at its March meeting, expanded quantitative easing, and announced a series of targeted long-term refinancing operations (TLTROs.). We believe that the TLTROs in particular could help boost lending into the economy, and support economic growth. The move has been helpful for credit markets in particular, and we remain overweight US and European high yield bonds. But markets identified a tension between the ECB's leading role in providing global liquidity, and indications from President Mario Draghi that the scope for further rate cuts was likely to be limited. 

In January the Bank of Japan (BoJ) introduced negative deposit rates for the first time. While the BoJ left policy on hold in March, a downgrade of its growth and inflation outlook leads us to believe that further easing is likely before July. We are underweight the Japanese yen against the US dollar in global portfolios. Despite Governor Kuroda's belief that the BoJ is not running out of policy options, uncertainty about the scope for additional easing is likely to persist. We keep a neutral stance on Japanese equities. 

China's policymakers are likely to remain accommodative, employing a combination of fiscal and monetary levers to manage a steady growth slowdown. Although markets should take comfort that capital outflows have eased recently, these concerns could resurface, particularly if the divergent Fed policy leads to additional dollar strength. 

The latest round of central bank actions not only highlights the divergence between the tightening bias of the Fed and easing in other parts of the world. It also underscores the increasing diversity of tools central bankers are willing to deploy to stimulate economic growth. 

While we applaud pragmatic experimentation, we expect some central banks to be more successful than others in achieving their targets. As mentioned above, we currently prefer to take exposure to riskier assets via credit over equities, since our analysis suggests that credit markets recover earlier from risk-off periods. We reiterate the need for investors to diversify their portfolios globally, given divergent policy trends and the likely volatility they could generate. 

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