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When reflation gives renewed credibility to the Fed and ECB

In the year to date, structurally low volatility has been a major market feature. The main central banks have played a crucial role in this situation.

The Fed kept to its strategy of monetary policy normalization despite the announcement of fiscal upheavals. Its key rates forecasts for the next few years are thus unchanged, which has clarified and lent credibility to its action.

Disproving the many international investors’ skepticism about its capacity for intervention, the ECB successfully dispelled the specter of deflation thanks to a wide array of non-conventional measures. Despite a persistently high political risk, the business climate in the Eurozone has improved significantly as a result, which should trigger GDP and EPS growth forecasts upgrades over the coming months.

The ECB’s success should generate a structural decrease in volatility of European risky assets as long as the political climate remains stable.

In our view, the optimism of the beginning of the year is much more vulnerable in the US than in the Eurozone. The failure to reform Obamacare showed that fiscal execution could turn out to be much more difficult than expected.

The minutes of the March FOMC meeting highlight the Fed’s plan to address a new challenge in its monetary normalization strategy, i.e. to shrink its balance sheet. This prospect may give rise to fears for emerging equities and lead to profit taking after the  eginning-of-the-year rally.

Japanese equities could capitalize on this configuration and recoup some of the downturn recorded in Q1 2017, although they have limited upside in the absence of domestic factors of support. Ultimately, our message today is more than ever to be exposed to the European recovery.

 

In early 2016, monetary policy decoupling between the Fed and the other main central banks contributed to the volatility shock in markets overall, triggering wide currency dispersion (and speculative attacks against the RMB) and disrupting commodity prices.

The Fed was unable to curb uncertainty around its exit strategy (making investors jittery at the time of FOMC meetings). In addition, the BoJ and ECB’s wealth of unconventional measures (notably putting key rates in negative territory) meant that investors ultimately lost their bearings. Since the summer of 2016, the Fed and the ECB have managed to re-anchor expectations, pushing down volatility to very low levels.

The Fed’s consistency, despite the announcement of major fiscal upheavals, has lent credibility to its exit strategy.

The Fed took advantage of improving confidence surveys and easing monetary and financial conditions (stemming from the equity market rally and credit spread compression) to raise the Fed funds rate twice in the space of three months.

Nevertheless, it has kept its provisional timetable to normalize monetary policy :FOMC members’ Fed funds median forecasts unchanged for the coming years / change in the balance sheet size further out -and the same tone in its monetary policy statements.

The Fed’s consistency, at a time when the expected fiscal upheavals are liable to trigger huge market volatility, lends credibility to the Fed’s action and enhances financial stability.

As a result, tensions on long-term bond yields and the USD have been contained, with the following consequences:

  • contain speculative positions on a downturn in the oil price, at a time when the oil price is being eroded by shale oil flooding the market again
  • prevent the weakening of emerging economies whose monetary and debt commitments are exposed to the USD exchange rate.

So far, it seems that the central banks’ exit strategy is playing out fine.