Rogge Global Partners is a $36 billion global fixed-income specialist based in London. Malie Conway, co-CIO and head of global credit, and Ranjiv Mann, head of economic research, discuss why US rates could peak sooner than projected and why renminbi weakness needs to be carefully managed.
Read their views on the prospects for the Chinese renminbi by clicking here.
Q: What explains the persistent gap between market and US Federal Reserve expectations for the trajectory of interest rate hikes?
Ranjiv Mann: The world’s economic cycle is clearly desynchronised. Developed markets are emerging from their deleveraging phase, while the emerging-market world is still in the midst of its deleveraging. The external environment is putting pressure on the US. This pressure explains why expectations of a Fed rate hike earlier in 2015 got pushed to the end of the year.
Q: The Fed did raise its federal funds rate, from zero to 25 basis points, in December. What’s cautioning it from further moves?
Mann: Now the Fed is watching the weakening of the Chinese economy, the possible devaluation of the yuan, and subdued inflationary pressures.
Q: Yet the latest jobs report in the US suggests a more bullish picture on the economy.
Mann: The US economy itself is broadly supported by real income gains. But while the slack in the labour market is eroding, the economy is only growing at its trend rate and domestic risks remain. So overall the bond market questions the Fed’s ability to make significant further rate hikes.
Malie Conway: The Fed got itself into this situation [in 2015] where it had to do something. It had been warning us about ending quantitative easing since 2013, at which point the markets had reacted sharply. The Fed does not want to get it wrong.
Q: How fearful is the Fed of committing a policy mistake?
Conway: For the last five or six years every central banker’s prayer at night has been, “Please don’t let me be the next Japan.” Given all the printing they’ve done (i.e., creating money to purchase assets), they want to avoid a policy mistake as they reach the last stretch of monetary expansion.
Q: The Fed’s so-called “dot plot” [its projected target for appropriate short-term interest rates over time] says it plans to raise interest rates four times over the course of 2016. Would that be a mistake?
Conway: The Fed is ahead of the curve on this matter, not behind. The Fed dot plot is the only predictive tool they’ve got left. They’re starting to raise interest rates, and flattening the yield curve. So far there have been no violent moves in the bond market as a result of the Fed’s tightening.
Q: Yes, they’ve mitigated a 2013-style tantrum, but bond market pricing doesn’t match a four-time rate increase.
Mann: Markets expect fewer: no more than two rate hikes this year. The terminal policy rate is likely to be much lower than in previous rounds of tightening. Inflation expectations, at least for headline inflation, will eventually drift upwards. The base effects for a higher headline inflation rate should start to kick in through this year. But the ongoing decline in commodity prices is pushing [an increase in] inflation out, and markets have less confidence that central banks can get anywhere near their inflation targets any time soon.
Q: Why do you doubt inflation’s return, despite all this money-printing?
Mann: We don’t see any inflationary impulse: factors such as money supply and wage growth remain subdued from a historical perspective. Markets are re-pricing the Fed’s interest rate outlook based on that.
Q: So you expect the Fed’s ‘dot plot’ to conform more to what the market is saying?
Mann: The dots may slowly come down if we don’t see the external environment improve. The Fed says it expects a stronger labour market, wage increases, and core inflation to return to around 2%. The only way to get there is if we have a weaker dollar, increased wages, and clarity that global inflation pressures are rising. According to our indicators, at this juncture, none of that seems achievable.
Q: How does that outlook feed into the global portfolio?
Conway: It’s incredibly difficult to have a high conviction in many positions. Essentially we want to be close to home. Over the past year and a half the message from the central banks has been that they’re watching market data, just like we are. That doesn’t give us much confidence. The Fed’s statements from one meeting to the next have been confusing. Many external forces such as China are beyond their control.
Q: When you say ‘stay close to home’, what does that mean?
Conway: Don’t take a lot of risk. Most developed economies are growing at, or close to, trend rates, which is being achieved through higher government indebtedness. Central banks have kept real interest rates very low to avoid a potential default. They are using currency as a balancing tool: going into the 2008-09 financial crisis, the dollar lost value; then it was the pound’s turn, then the yen, then the euro, and now it’s Asian currencies. This just creates instability. Gold’s price peaked in 2012 and since then commodities have been in decline. There is a rising probability of a major financial crisis. In fact, we’re now facing a crisis among emerging markets: every EM asset class is distressed and the market has lost confidence in [the Chinese] authorities since August 2015.
Q: How do you de-risk without crushing returns?
Conway: We are slightly long credit. We are significantly underweight triple-B-rated bonds in industrials, energy and mining. We’re long double-B-rated bonds, usually short duration, issued by companies that offer good visibility on their earnings – well-regulated utilities, for example. We also like some European commercial mortgage-backed securities, again keeping to short durations.
Q: Any country picks?
Conway: We haven’t got strong views today. Normally, relative value among countries is one of Rogge’s strengths but right now we don’t see any relative-value trades.
Q: How are you playing the US yield curve?
Conway: When it comes to duration we’re staying close to [the] benchmark. We’re a little worried about sovereign wealth funds selling their holdings of US Treasuries for liquidity purposes. The US 10-year Treasury still seems to be at fair value.