investment insights
Rate minds don’t think alike
Key takeaways
- Monetary policy cycles are reaching a turning point across the globe. The Bank of Japan dropped its negative interest rates, and we see 0.5% as the peak of its hiking this cycle, limiting the impact on global asset flows
- The Swiss National Bank’s decision to cut rates was easier than the choices faced by the Federal Reserve and European Central Bank. The latter two should ease policy from mid-year
- A shifting rate cycle is supporting markets, but a soft landing is already priced into many risk assets. We keep an overweight to the US dollar and sovereign bonds, with a bias to add duration as cuts unfold
- Our recent changes to strategic asset allocations reflect an environment of higher neutral rates and higher expected returns. Our portfolios now have more exposure to ‘core’ assets, including fixed income and private assets, where possible.
An historic week for central banks has seen a new rate cycle begin. The Swiss National Bank became the first in the G10 to cut interest rates while the Bank of Japan finally ended negative ones, both marking a return to more normal monetary conditions. Cuts in the US and eurozone still look on track for June. What do changing rate dynamics mean for investors?
The Bank of Japan (BoJ) closed a chapter in monetary history in March, becoming the last remaining central bank to raise rates above zero. The bank also ended its yield curve control policy – of intervening to keep 10-year government bond yields below a fixed cap – and stopped purchases of exchange-traded funds and real estate investment trusts. Japanese inflation finally looks sustainably above target, helped by a firm shift in long-term inflation expectations and a 5.25% average wage increase in recent union negotiations.
Limited global ramifications from the BoJ move, for now
The wage negotiation result for the coming tax year represents the largest raise in 30 years and was likely the key factor that nudged the BoJ to act. Its move caused surprisingly few ripples in financial markets despite being the first tightening in 17 years. Well-timed leaks in the local media warning of imminent policy changes helped, but the BoJ’s carefully balanced guidance on future tightening prospects probably played a much bigger role.
Anxious about potential strains that any significant hawkish surprise would put on the economy and government finances, the BoJ refrained from steering expectations in either direction and has made additional rate hikes conditional on “bigger upward price risks”. This helps explain the market reaction: a lower yen, higher Japanese stocks, and longer-dated Japanese government yields range-trading.
In our view, the Japanese economy has a good chance of generating above-target inflation in both 2024 and 2025. If we are right in this outlook, we expect the BoJ to raise its short-term rates by 10 basis points apiece in its July and December policy meetings. Even in this base case scenario, we currently see 0.5% as the ceiling of this hiking cycle. In addition to the low neutral rate for the economy, the BoJ faces the risk of financial losses if rates rise past 0.5%, partly due to the sheer scale of commercial banks’ reserves with the central bank after a decade of quantitative easing. While paper losses are not a rarity in the central banking world, Japan’s high public debt levels would make such a scenario at least politically tricky.
The global impact of the BoJ’s move has been muted thanks to the fact that Japanese financial institutions have already reduced their exposures to US dollar debt in recent years. If anything, the resilience of the US dollar against the yen and of Japanese equities to the BoJ’s policy move could embolden retail investors to keep buying foreign assets. From now onwards, the BoJ will likely let the Finance Ministry cap any downside for the yen with verbal or actual currency market interventions.
First move from the Swiss National Bank
The message from a series of central banks last week was that global borrowing costs are set to fall. In a move that broke ranks with its peers, the Swiss National Bank (SNB) became the first major developed central bank to cut rates. Central bank decisions in both Switzerland and Japan indicate gradual economic normalisation: from the pandemic and energy shock in the former, and from years of stagnation in the latter. In many ways the SNB’s choice was obvious. Inflation had not climbed as high as in other countries, has been within target for months, and wage dynamics are under control. The SNB never raised rates as high as other central banks and may make fewer cuts: we expect two more in June and September to take rates 50 basis points (bps) lower by year-end.
In other major economies, things are less clear cut. Recent inflation data in the US, eurozone and UK showed more persistent-than-expected services inflation. In the US, this has led markets to push rate cut expectations forward. But at its March meeting, the Federal Reserve (Fed) kept its forecast of three cuts in 2024. Chair Jerome Powell put less emphasis on temporary hot inflation components and focussed on cooling wage trends, the major driver of services inflation. The European Central Bank (ECB) sent a similar message at a key conference last week, while the Bank of England (BoE) is also lining up for rate cuts. In the BoE meeting last week, two members of the rate-setting committee that had previously favoured additional rate increases voted to hold rates. We expect policy easing in the US, eurozone and UK to start in June.
Lining up a soft landing
This shifting rate cycle is supporting markets. Global growth is recovering, inflation is normalising, and rate cuts lie ahead. The Fed revised its 2024 US growth forecast up from 1.4% to 2.1% at last week’s meeting. An unusual situation of improving productivity and Chinese goods deflation has bolstered hopes that recovering growth can coincide with lower rates. A soft landing remains our core economic scenario.
This expectation is already reflected in the price of many risk assets, meaning we keep portfolio risk and equity exposures at strategic levels. Yet improving fundamentals mean we would consider taking advantage of stock market corrections to add to positions. Meanwhile greater divergence among central bank policies globally, after rates climbed for much of 2022 and early 2023, should lead to increasing divergence among regions and sectors, presenting opportunities for active investors.
Higher ‘neutral’ interest rates and asset class returns
We also expect an era of slightly structurally higher inflation and interest rates than pre-pandemic. This is because Covid has increased the willingness of governments to provide fiscal support, while rising geopolitical tensions and competition have led to a fragmentation in trade and supply chains, with both tending to drive prices up.
The Fed slightly raised its estimate of the ‘neutral’ interest rate at its March meeting to 2.6%, while we estimate it to be 3.5%. Our recent changes to strategic asset allocations reflect this environment of higher neutral rates and higher expected returns. They have led to portfolios with a simpler architecture and more exposure to ‘core’ assets, including fixed income and private assets, where possible.
Bonds should come into their own
From a tactical investment perspective, a peaking rate cycle in developed markets is the time to lock in higher yields. Yield curves are increasingly reflecting this new reality, as short-term rates fall faster than longer term ones. We keep our tactical overweight to fixed income. Our earlier focus on US Treasuries now extends to euro and UK sovereign bonds too, where we retain a bias to add duration as rate cuts unfold.
Currencies also reflect changing rate dynamics. Low yielders such as the yen and Swiss franc have already weakened against the US dollar year to date. We expect this trend to continue short-term but take a more constructive longer-term view on the franc and expect EURCHF strength to reverse in the second half. Following the BoJ move, USDJPY will likely remain around 150 in coming months, and could be volatile this year as Japanese monetary policy continues to normalise. In 12 months’ time we see a yen recovery driving USDJPY to 138. We keep a dollar overweight in portfolios given its yield advantage, and the support it enjoys from a resilient US economy and soft global growth.
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