The Federal Reserve is unlikely to speed up the process of normalising interest rates this year, with a lack of inflationary pressure on central bankers meaning there is no rush to hike more aggressively and cause repercussions for fixed income markets, Kames Capital’s Juan Valenzuela says.
While there has been some initial volatility this year as the macroeconomic picture shifts to focus on the return of inflation, Kames’ fixed income team does not foresee a sharp spike in inflation which would cause the Federal Reserve and other central banks to act more aggressively. As such, it expects a more benign environment for fixed income from here.
Valenzuela, co-manager of the Kames Strategic Bond Fund, says: “Central bankers will feel relief, not fear, and fundamentally, we do not believe that the volatility experienced over February changes the macroeconomic picture. Despite the level of economic activity, the current level of growth does not require an aggressive response from central banks.
“As such, we still expect a benign combination of accommodative monetary policy (but less than in previous years) that is complemented by a relatively stimulatory fiscal policy. We expect growth to remain above capacity, but at levels similar to what we experienced in 2017.”
While inflation has risen off lows, Valenzuela says this is simply “normalisation” driven by limited slack in the employment market, as well as by strong growth.
He says rather than fear it, central bankers are likely to welcome the rise in inflation after years of battling with deflationary forces, and as a result he expects they will not be minded to change course in the near term.
“After an extended period of below target inflation, the Federal Reserve is unlikely to feel the need to speed up the pace of normalisation,” he says.
“We expect the Federal Open Markets Committee to continue increasing rates this year; three to four rate hikes in 2018 is a reasonable assumption. The terminal rate is very likely to end higher than the market is currently pricing (approximately 2.5% by 2020), but we do not believe the Fed will feel that it is currently behind the curve.”
Meanwhile in Europe, Valenzuela adds expectations of interest rates are currently more reasonable than they were towards the end of last year.
“We expect the ECB to end QE in late 2018 and, in-line with market pricing, not hike until the first half of 2019,” he says.
“Ultimately, we believe the path of rate increases delivered by the central bank will be speedier than what the market expects. However, higher inflation is required for yields to move meaningfully higher, which is something that is unlikely in the short term.
“Interest rates are effectively in the lower bound, and with headline and core inflation depressed (with risk to the downside), we expect a cautious recalibration of policy, particularly in light of the stronger currency. After all, central bankers will not want to find themselves at the lower bound when the next downturn takes place, but equally they will not want to cause it.”