2016 is turning out to be a year where global central bankers are finding out what they cannot do.
China found out early in the year that currency depreciation can no longer be used as a source of stimulus without causing panic in their equity markets and large capital outflows. The ECB and the BoJ later discovered that policy rates cannot be pushed deeper into negative territory to boost growth without damaging domestic banks’ profitability and share prices. Even the Fed has come to the realization that interest rates could not be increased as much as planned without causing troublesome gains in the overvalued U.S. dollar.
The move to less-active central banks has been very supportive for global fixed income markets over the past couple of months. Government bond yields remain at very low levels with monetary policy still highly accommodative and global inflation subdued. Overall market volatility has declined, supporting rebounds in beaten up credit markets. Some tentative evidence of an improving Chinese economy is also helping support the rally in global credit markets (please see the latest Inside BCA for a set of charts that will help track Chinese and global growth dynamics).
Nevertheless, the investment backdrop remains challenging. The U.S. remains stuck in a strange world where corporate profits are contracting yet employment and consumer prices are both growing fast enough that additional Fed rate hikes are possible, perhaps as soon as June. Growth and inflation are slowing in Japan and the euro area, yet governments there remain unwilling or unable (or both) to boost growth via fiscal stimulus, forcing the BoJ and ECB to consider more radical easing measures with lower chances of success like negative policy rates, corporate bond purchases and even so-called “helicopter money”.
Amid an uncertain growth and policy environment, the current low volatility backdrop is unlikely to be sustained, according to our global fixed income strategists. Investors should maintain a defensive stance in fixed income portfolios, remaining underweight credit while minimizing exposure to the negative-yielding bonds in core Europe and Japan.